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Canadian National Railway (NYSE:CNI)

Q2 2010 Earnings Call

July 22, 2010 4:30 p.m. ET

Executives

Robert Noorigan - VP, IR

Claude Mongeau - President & CEO

Keith Creel - EVP & COO

J.J. Ruest - EVP & CMO

Luc Jobin - EVP & CFO

Analysts

Jason Seidl - Dahlman Rose

Bill Green - Morgan Stanley

Chris Ceraso - Credit Suisse

Jacob Bout - CIBC

Ed Wolfe - Wolfe Trahan

Walter Spracklin - RBC Capital Markets

Tom Wadewitz - JPMorgan

Cherilyn Radbourne - TD Newcrest

Ken Hoexter - Merrill Lynch

Scott Malat - Goldman Sachs

Sal Vitale - Sterne Agee

Operator

Welcome to the CN Second Quarter 2010 Financial Results Conference call. I would now like to turn the meeting over to Mr. Robert Noorigan, Vice President, Investor Relations.

Ladies and gentlemen, Mr. Noorigan.

Robert Noorigan

Thank you Dave and thank you for joining us for our second quarter 2010 financial results. I would like to remind you again about the comments that have already been made regarding our forward-looking statements. With us today is Mr. Claude Mongeau, President and Chief Executive Officer, Luc Jobin, Executive Vice President and Chief Financial Officer, Keith Creel, Executive Vice President, Chief Operating Officer and J.J Ruest, Executive Vice President and Chief Marketing Officer.

After the presentation we'd like to take questions from those of you who are listening on the call, would you please identify yourself on asking the questions and we'd really like to be fair to everybody, so could you limit yourself to one question with one follow-up. Thank you.

With that it's pleasure to introduce Mr. Claude Mongeau, CN's President and Chief Executive Officer. Claude?

Claude Mongeau

Thank you Bob and thank you all for joining us this afternoon. We are very, very pleased to announce our second quarter results. They are good results. The economic recovery is taking hold, and we were able to turn in both solid earnings growth, and strong free cash flow generation on a year-to-date basis.

Our EPS for the quarter is specifically of $1.13 which is up 38% from last year on a reported basis, but if you look at in on an adjusted basis, it's up actually close to 50% on a year-over-year basis.

This was driven by the top line. The economy obviously held being, but also our service and our ability with careful planning to handle the business with Keith clearly some sectors and I just mentioned a few here J.J. will give you a more detail with automotive at 52%, coal at 49% and metals and minerals at 46%, it takes a lot of solid work and careful planning to be able to help your customer handle that kind of growth in a short period, especially coming back from the deep recession that we all face last year particularly in the second quarter actually of 2009. So, our revenues overall are up 18%, the volumes are up 27% on a carload basis and 15% on an RPM basis.

The main difference between the two is mostly around short-haul iron ore movements but both indicators show the strength of the recovery up to now in 2010. We are trying to do our best to help our customers with strong supply chain focus and service improvements to accommodate that business growth and we are doing so at the low incremental cost.

Our operating ratio is improving quite significantly on a year-over-year basis, till bit more than six point. Keith will give you some of the key details why we were able to do so. Clearly, our precision rail road model, our focus on operational excellence and our goals to accommodate business at low incremental costs is clearly coming through and that reflects itself in the earnings momentum and the improvement at the level of operating ratio.

I said earlier our free cash flow was very strong indeed, Luc will give you more detail but for the first six months we are at around $958 million of free cash flow generation clearly a strong performance, some of it driven by the sale that we were able to do earlier this year but nevertheless strong, strong free cash flow generation that bodes well on a go forward basis to our ability to create shareholder value.

Just turning briefly to the next stage in your presentation, I just want to say few words about how our game plan is unfolding. This is the second quarter that we report as a new executive's team here at CN and we are basically firing on all cylinders. Our strategy is working, everything is with precision railroading at the core but clearly our focus on accommodating the business at low incremental costs is coming through.

People were concerned that with the added volume, you would see some of the fluidity and velocity metric suffering and that's clearly not what we are seeing. We have been able to continue to improve in this regard and that comes true in terms of our results.

The more important point is we are improving in terms of velocity and fluidity and key productivity metric at the same time as we are improving service metric for our customers.

Our focus first mile and last mile, our focus on supply chain initiative and our focus on engaging to understand our customers business is paying dividend and we are continuing to focus in this regard. We call it deeper customer engagement or supply chain innovation. At the end of the day it's about finding ways to work hand in hand with your customers so that we can help them grow and as they grow help us bring the volume, the top line to our bottom-line so that we can continue to create shareholder for many years to come.

At the moment can do so as we accommodate the economic recovery which we hope will continue despite the uncertainty that it will continue into the balance of the year for 2010 and outlook we will give later a little bit more about how we see the world unfolding for the balance of the year.

So, with this I will turn it over to the team starting with Keith Creel.

Keith Creel

Okay, thanks Claude. As you captured in your comments, solid team execution continues to be a key ingredient in our success story. As the operating guy, I'm honored to lead the team that executes this operating model day to day and we do it by insuring we operate in an environment that above all else will protect the safety of our franchise or employees and the communities we operate in and through. In return this environment gives us a sustainable platform that allows us to deliver the superior service that our customers deserve and expect and do it at the same time with tremendous operating leverage that has allowed us to absorb the volume growth we've experienced at a very low incremental cost.

As you can see from the quarter's financial results, they indicated that that's a success in this area but at CN we realize one thing, financial success is only the output of our efforts. So let me take a moment to walk you through some of our key operating metrics and our initiatives.

So the operational highlight thus far that you're looking at, some of these metrics we share with you each quarter with a small addition I'll mention at the moment about our terminal well and training velocity measures that we've added to this portfolio. Starting with the upper right side, you can see that we've continued our improvements in train load measured in GTMs per train mile.

This is a railroad raw productivity at its best. Our highly safe and efficient eco friendly trains which I've heard some refer to as long trains draw the best use of crews on locomotors fueling our network capacity resources and investments. The 7% year-over-year improvement you see was driven by a careful management of our train starts as our traffic started to ramp up, continue to ramp up through the year.

Our distributed power initiative continues to pay benefits as more and more of our traffic is moved and our safe high efficient DP trains, approximately 35% of our road fleet is now DP equipped and that number will move to about 50% by the time we finish our 2010 and 2010 locomotive plans. This goes hand in hand with our (inaudible) shock capacity investments, speed enhancements in our network which I'll discuss in a moment as well.

The net result is more traffic on the same number of trains which obviously provides the tremendous operating leverage that we benefit from. Below that you can the locomotor productivity measured as GTMs per available horsepower continued its record improvement as well. This is a reflection of the increase in trainload that I just mentioned and our culture of continuously matching our locomotor fleet inventory to the workload at hand.

And like any railroad a lot of our expense in generated in our yards. This represents a significant opportunity for delays and disconnections and service issues but this is an area that we have always focused on and will always focus on. We measure the results here in a measure we call cars handled per yard switching hour. The key levers include minimizing your car inventories. You continuously adapt your service plan with a view to minimize your car handling, match your yard resources to the demand and your overall network strategy that we've deployed which maximizes the workload at our low cost operating or processing centers, Winnipeg, Toronto, Chicago, Kirk yard and of course Memphis.

Next is car velocity which we measure in car miles per car day. As you can see this metric is basically year-over-year. There is a couple of things here that happening with respect to mix. Some of the growth we've had at some of our slower moving fleets which impact that number and also the fact that spent all the second quarter 2009 literally stuffing over 25,000 cars into storage with the economy. And then of course, the rate that we've added service back in 2010, we've been very judicious with it. So you've not seen the stepped improvements that driving the flat year-over-year comparison.

Having said that, the main reason we look at car velocity domain day-to-day as a parameter of our proper inventory as far as our fleet management and here I can you the team did a respectable job. J.J. is going to tell you in a minute we moved about 15% more RTMs in the quarter versus last year with active low inventory that was approximately 5% higher than 2009. And at the same time our car order fulfillment rate was up 2 points year-over-year as well as we focused on filling our short lead time orders.

On the note on the right hand side of the page, you will see that commencing this quarter we've adopted the industry standard AER measurements for terminal Dwell and for train velocity. Along with that change of measures are available directly on AER website along with those of our peers.

You can see from the time series that our efforts to drive out all types of failures, eliminate network bottlenecks and increase tracks to key locations are all having the desired effects. So, this year for example, we are going to continue spending two timings of our Edmonton and Prince Rupert corridor, two others on the Winnipeg Chicago corridor, and one on Northern Ontario and at the same time build a much needed bypass track runner yard with Eskaton.

And we've also placed investment programs to increase our track speeds in the superior area which will allow our trains detect some of our most challenging grids on our system with our initial train velocity.

Operational overview and I hope you would agree that this team of railroad has continued to deliver on the operating side. This productivity metrics we produced allowed us to tell J.J. and its team to keep selling and move the business at a very low incremental cost. And we will harvest it to the bottom line since we recovered to this economy.

In line with closed leadership, and our collaborative operations marketing approach, this operating team does not satisfy with just having J.J., and his team grow in step where they recover. We want more business than that. We want more customers, we want more financial customer, and we are prepared to doing it one carload at time. So, both myself and my operating team, it's clear to them in our schedules to work directly with the marketing team and engage with our key customers accounts. You probably read about some of the supply chain collaboration agreements, than CN is pioneered under Claude's leadership as well.

Making this collaboration agreements are more, be more than just words on paper across significant amount of working commitment. Rest assure myself and my team are directly engage with the supply chain partners while at the same time, I'm standing side-by-side with our marketing peers, and the key individual accounts.

As far as our pipeline and productivity initiatives, those continue we add to them. This includes car shop consolidation. This quarter we've closed the car shop at Ontario. We will close fund like in August. Our locomotive fleet plan that we talked about previously has come together with [62 Dash 8], now [inline] has given us about 15% fuel efficiency gain over the locomotives that they have replaced. DP of course, continues to be a key piece of that strategy.

So, with that said, I'll turn it over to J.J. for the marketing review.

J.J. Ruest

Excellent, thank you Keith. If we could join me on page 10, the graph or the colored graph, the second quarter, really began where we left, we left it up from the first quarter, and we continued sequential improvement growth in our volume.

We have 37% sequential carload growth from the first quarter of this year. We had 27% carload growth from the second quarter of last year. And this fully reflect the stronger than expected recovery in North American GDP and the industrial production.

It is also reflecting of the impact of marketplace of our improved services. Some of them Keith mentioned, like for example, first mile manufacturing sector, the scheduled service that we offer to all customers as well as our very strong focus on container velocity across the supply chain and intermodal when it’s on the railroad.

And not to say the least, our -- we are all engaging with customers. You have heard Claude, Keith, Luke and myself and all the senior leaders in the operation and marketing spending increasing amount of time with customers and understanding their needs and what creates value for them.

We go to page 11, slide 11 to see the number for the second quarter. During the second quarter, with the support of our customers, our revenue were up 26% on an exchange adjusted basis. If you break this down, again on a tax adjusted basis for the quarter, it is explained as follows. 15% of the increase in revenue was related to volume, rail volume, more reflective by the RTM, also which was up 15%. RTM is a much better measure of our volume due to the significant increase in our R&L business which is relatively short haul versus our other carload business. We have also increased our revenue from price, same store price remain about 3%, however, when one adjust for the Canadian regulated rail and our legacy contract which I have some RCF type pricing, our core pricing with that been offering about 4%.

We have also obtained 4% increase from our fuel surcharge revenue because of this significant and higher WTI and highway diesel pricing compared to last year. Also because of our industry leading 90% universal application of our fuel surcharge program, which really is up to 98% when actually regular grain as well as the RCF legacy contract that we have.

Other revenue we're also contributing through the total contributing 4% and these other revenue were driven by our vessel and dock, mostly iron ore as well as significant turnaround in our automotive business, Autoport as well as transport activities as it relates to carload.

Now, going to the major segment, starting with manufacturing. The manufacturing sector contributed C$216 million of growth on an exchange adjusted basis for the quarter. Petroleum and chemical was up 16% mostly because of improvement and industrial production and refined product.

Metals and minerals was up a whopping 46% but that's because specifically of the major impact of iron ore, but also because of the continued recovery of the steel segment which is now running up, and around at 70%, it kind of went up to close to 74 went down back a bit fluctuating at a good pace. All of this actually played a very increase in carload, not only for iron ore, but also flat role for lock and load product.

Also our success in metals and minerals are related to Keith's teams effort and focused on the first mile which has also produce some extra point of market share against the trucking, our trucking competitor in the steel market.

Forest product was up 16%, and part of the restructuring activities in North America as well as export to China. Automotive was up 52% because of the stronger potassium level from the CN circular family that we have in Ontario and Michigan as well as our entry in Chicago dealer market by reopening of an Autoport back in (inaudible) in Chicago at the beginning of the year.

Our bulk segment was up C$73 million on exchange adjusted basis of which coal contributed 29%. We have very strong offshore demand from China, Korea and Japan of Canadian met coal as well as Canadian oil sand met coal products. Our U.S. thermal coal carload have also increased 19% in the quarter which was a nice thing to see.

Grain and fertilizer was up 6%, on the back of increased demand for fertilizer most of the potash have also gone however this was offset during the quarter by volume of export seed grain mainly oat and wheat.

Finally, but not least our (inaudible) business was up C$91 million on exchange of adjusted basis in the quarter or 25%, we have raised again for the next port on the West Coast in June the port of Vancouver volume reached a level similar to 2008, which was nice to see. Our activities at Rupert have also seen new all time high with its was bigger three vessel per week services.

Retail volume on the domestic side are continued to improve reflecting the improvement of the Canadian economy, but also as well as the traction of our very strong customers engagement in the marketplace. All-in-all, we had a great quarter which we are very pleased with and pleased with the support from our customers.

If we move to slide 12, just for short outlook, on the manufacturing sector, we expect carload to remain on the same page or the same range. The North American industrial production anticipated to remain in the same range. We see some melt in the case of forest products to come back or it's for lumber or wood pulp which will increase carload available to us coming from our preferred customers. We also received some ramping out of construction aggregates, specially north in Alberta, with the oil sand and activities in oil and gas is coming back definitely this year versus last year, as well as the result of our customers engagement as we further roll out first mile, last mile initiative in the carload market.

On the bulk side, the price and demand for offshore met coal is very strong as well as petrol. A long summer has helped thermal coal in the U.S. which is expected to continue for the balance of the year. The Canadian Green seedings were very low this year as a release of this pass, but we expect the crop, therefore to be lower. We've had a good carryover from the last year, and when you combine that with our new schedule of grain service which will be this time ready for the beginning of the crop.

We expect the impact of the smaller seeding for mostly in our case of CN. I think that then else in 2011. The U.S. crop is promising on our substitution late this fall. We are on standby to be able to handle one of our customer, we are going to be receiving as orders from there, from their own customers.

Finally in Edmonton, the Asian container import in July is considered to be very strong as well as the export of goods and empty containers in July, also very strong and the Canadian retail volume continued to improve steadily as our customers business expands and we continue to focus on our service in the environment where we are competing with truck and truck supplies are getting tighter.

In conclusion, we are positive about the business prospect for the second half of the year and we are definitely gaining momentum with our strong customer's engagement as well as supply chain approach initiative with a huge takeovers like port and terminal. For the total year we are looking for volume growth in the mid-teen area.

Luc Jobin

Thanks J.J. Well, it's a pleasure to be reporting great results for the second quarter and certainly in as well for the first half of 2010. I think we set out, that we are achieving what we set out to do, which was to leverage to the economic recovery and our results are showing that in stage. As Claude pointed out we are -- we have been making progress on all key performance metrics, whether they are operating productivity, service related in terms of providing the great service to our customers and our financial results for our shareholders.

We are delivering adjusted EPS of a $1.13 for the second quarter, and that's a 49% improvement over last year. Indeed when you adjust for foreign currency, you actually get 59% improvement over last year. As J.J. pointed out we actually made some strong progress in all parts of our business, and this was obviously comparing to the last year which was the troth of the recession. Our revenues came in at C$2.1 billion which s up about 18% versus last year and up 20% on an effect adjusted basis.

We also saw growth in all our commodity groups and our RTMs as was previously mentioned, increased 25%, our carloads 27%, our operating ratio was a low 61.2% in the quarter, and which was at full six point improvement and for the first half of 2010 our operating ratio stands at 65.1%, which is a full four point improvement over the last year.

Turning to expenses for the second quarter, our total expenses came in just under a 1.3 billion which was up 7% versus 2009 and on an FX adjusted basis, that do translates to about 15% increase. The major area category of increase was in the fuel line which was mostly due to higher prices. The WTI went from C$60 last year to C$78 this year.

As well the volume obviously was a big contributor and that was partly offset by continued improvements in terms of our fuel productivity where we had about a 3% improvement in the second quarter.

Our labor cost went up about 6% on a FX adjusted basis versus 2009 the principle reason for the change was wages which increased and a little bit more overtime. On the other hand our manpower was up as well a little bit 1%, so a very small increase in terms of overall manpower, 1% overall however, we probably had about 3% in the running trade.

In terms of other changes, casualties and others up little bit from last year, an increase of about $C30 million in second quarter mostly due to some higher legal and environmental costs across several small items.

However, I should point out that on the first half of the year we are tracking with last year and we were about C$4 million above last year on an FX adjustment basis. It's important to go back and just keep in mind that these financial results are stellar. These expense levels in terms of the business that we have been able to accommodate are exceptional.

The train load actually went up 7% to about 8000 gross tons and for train our cars handle per yard hour has gone up 9% and our labor productivity in terms of million GTMs was up a solid 13% just exceptional productivity results from Keith and his team.

Turning over to free cash flow, as Claude pointed out C$968 million of free cash generated in the first half of 2010 and that's almost C$500 million more than last year.

Obviously, that is attributable to better operating results as well as lower cash taxes in Canada and the sale of our Oakville subdivision to GO Transit in the first quarter of 2010.

We continue to accomplish our objective in terms of repurchasing our stock, our share buyback program. We have not completed slightly over half, so we have about 7.7 million shares which have been bought back in the first half of the year. We have a net debt position of about C$5.6 billion and that is net of about C$900 million of cash which we had on the balance sheet at the end of the second quarter.

Now let's turn to our updated financial outlook for 2010, as you can see we have had very, very strong first half results and we expect the economy to continue on its gradual course of recovery.

We are mindful of some of the concerns in terms of some parts of the economy and we do expect the pace of growth to be lower in second half simply because we also were seeing some of the start of the recovery back in the second half of 2009.

We don't however at this point and J.J. I think covered that in quite some detail. We were not seeing any slow down in terms of our traffic and we do not expect a double dip economic scenario at this point. On that basis our revised guidance is for adjusted diluted EPS. We believe we have the scope to achieve an increase of approximately 25% in 2010 over 2009 which was at the $3.24. As well we see our 2010 free cash flow which stand in the range of about 1.1 billion.

Now that's as well reflecting the very strong cash that we generated in the first half of the year. Our interesting earning forecast, the proceeds that we realized on the sale of our Oakville subdivision as I mentioned in the first quarter, and lower cash taxes in Canada.

We're using this opportunity as we expect to make an additional voluntary contribution to our pension plan in the order of C$250 million. This will come and to improve the funded position of our plan as we feel that it is prudent given certainly the less than stellar equity returns that we've seen and the prospects for a continued low interest environment at least for the short-term.

All of that will translate into solid shareholder value creation. On that note, I'll turn it back over to you Claude.

Claude Mongeau

Well, thank you Keith, J.J. and Luc as you can see they are here. Clearly this leadership team is clicking. We are delivering on our game plan. We are trying our best to help our customers accommodate the recovery and from our side, we are leveraging it by accommodating at low cost. There is strong team execution. We are focus on our mid to long-term game plan with the range of initiatives many of which are focused on engaging with our customers and finding way to continuously improve our business from the platform of operational excellence that has made CN what it is.

So, our focus is on keeping the momentum. I think the guidance that Luke is giving you for the balance of the year if the economy holds on its spats of recovery is something we can deliver, and if we succeeded that we should have a strong finish to a what is the first year for the transition of this new leadership team. With that I'll open the operator to questions.

Question-and-Answer Session

Thank you. Questions will now be taken from the telephone lines. (Operator Instructions). Our first question is from Jason Seidl with Dahlman Rose. Please go ahead.

Jason Seidl - Dahlman Rose

Good afternoon gentlemen. If I can, just on the guidance on the cash flow side, seems a little low concerning what you guys generated in the first half of the year when you almost done a billion already, and I get there to be paying out another C$215 million. Do you have more capital spending plan for the back half of the year than you did in the front half?

Claude Mongeau

I mean we have about a C$1 billion or so of capital spending, which will be taken place in the second half. I mean this is consistent with the C$6 billion capital program that we've laid out, and if you look out and the results we got about 0.5 billion or so done in the first part of this year.

Jason Seidl - Dahlman Rose

Okay, that makes sense. It's the extra CapEx plus the initial 250 payout, and that's -- that will makeup the difference, right?

Claude Mongeau

That's correct, Jason.

Jason Seidl - Dahlman Rose

Okay, perfect, thank you. I appreciate that. My next question you guys obviously have had a little bit of slowdown or at least the work stoppage in the Port of Montreal. I wonder if you can give us an update on where we stand right now.

Claude Mongeau

Well I think the parties at the Port of Montreal are in discussions as we speak and we are hopeful that they will find a resolution to the conflict in the labor dispute in short order. My comments would be the following. I think it just goes to show while important, railroad and port infrastructure are the economic backbone of both countries in North America. And it just puts a lot of emphasis on making sure the parties find ways to come to agreements without such labor dispute. I'm hopeful that they will do so in short order.

In the meantime for us the impact is not really material. We are trying to help our customers handle the business. Some of them are moving to other ports including ALIPAC and we are working in partnership with terminal operators and other stakeholders to try to minimize the impact the cargo owners of this labor dispute.

Jason Seidl - Dahlman Rose

Claude, what I found initially was that when you go on your customer site today, this sticks at a second place to a little blurb that you guys had put up there about hey, CN is ready for peak season and listening to sort of all the steps that you've taken to prepare for the additional freight coming on, could you talk about that? Do you have a lot of shippers calling up and asking if you guys are prepared for this peak season and just talk about the expectations and the mood this year versus maybe the prior three?

Claude Mongeau

Well I think our customers are able to see what this theme is able to deliver as speak. I just go back to what J.J. was explaining to our. Our overseas business for instance, international containers has been a -- its been a very, very strong surge for the last two months or two months and half on both coasts, both on the west coast and the Vancouver and Prince Rupert but also here in Montreal and ALIPAC across the board. So we are showing our ability to accommodate that business. It's not without challenges. We've had some hiccups inside our terminals for instance in terms of our ability to serve the trucking community in short timeframes and with the so called card time and other small issues to that effect but what our customers are seeing is that we are able to accommodate very strong growth while improving service levels and that bodes well for the balance of the year.

Jason Seidl - Dahlman Rose

Well okay guys. Thank you for the time as always. I'll let somebody else have at it.

Operator

Thank you. The next question is from Bill Green with Morgan Stanley. Please go ahead.

Bill Green - Morgan Stanley

Yeah, hey good afternoon. I wanted to ask about the OR. So if we think about the investor day and some of your longer term targets there you're already better than that here in the second quarter and I realize this can bounce around a bit but how should we think about the fact that you're better than sort of the longer term guidance. Does this mean that you're going to try to just grow the earnings faster here even if it means higher OR, or how we reconcile this to?

Claude Mongeau

Bill let me put it to you this way. Our CFO has given you a guidance from kind of sustainable mid to 60 operating ratio. If you look at the first half of the year, that's exactly where we are, at around 65%. I stand by his guidance for the long term but we'll certainly do everything we can as a team to beat it if we can and for sure the second quarter result and our ability to accommodate the initial rebound of growth at a very low incremental cost bodes well. At some point though you do get step functions and that initial capacity available has to be lapped out and you have to add resources more in sync with volume growth. So, we'll do our best to meet or beat the guidance that we have given and over the long-term, we will see whether we're able to do so.

Bill Green - Morgan Stanley

Okay. So, along those lines, how should we be thinking about the headcounts as your volumes grow from here? Could it stay flat on a full year basis in 2010 or is it sort of now we have already hit that influx and we've got to start adding back?

Claude Mongeau

Our headcounts are up 1% in the second quarter, with about 3% increase in our running trade and we're doing everything to stay ahead of the curve, and we have opportunities for productivity gain in certain areas and we will make sure we have running trades and locomotives engineers are ready to accommodate the business going forward. So, I think the model we've discussed is something that would have us grow our workforce in line with the business volume overtime, keeping in mind that we're trying to accommodate the business with productivity gains and the growth would not be proportional.

Bill Green - Morgan Stanley

Okay. Thank you for your time.

Operator

Thank you. The next question is from Chris Ceraso with Credit Suisse. Please go ahead.

Chris Ceraso - Credit Suisse

Thanks. I actually had a follow-up on the labor question. Is there a contractual increase in wages that kicks in the second half or what do we expect for the balance of this year and next year on the wage rates?

Luc Jobin

I mean, we have collective agreements which have been adopted. So, we are looking in roughly, I mean, ball park about 3% growth in terms of wages. But there is no significant change in the second half versus the first half.

J.J Ruest

No main change. We may have, but the Board has settled with the PCRC. But that's going to be second half on.

Chris Ceraso - Credit Suisse

So, you had a 3% increase in the first half versus a year ago. So, you have managed to keep wage and benefit costs flat year-over-year despite that?

Claude Mongeau

Actually if you look at it on a exchange adjusted basis, our labor expenses up about 6%, Chris, and 3% or so is wage, a little bit more from adding overtime, and the rest is slight increase in workforce and noise around other aspects of labor expense.

Chris Ceraso - Credit Suisse

Okay. That makes sense. And actually, a similar question with regard to the effective FX, how much of the difference between RTMs and carloads was FX versus mix or other factors?

Claude Mongeau

Yeah. There shouldn't be any impact there, Chris, because, you know, our carload is carload. This is physical count and we have more carload growth because we have a lot of short haul movements, particularly the iron ore. Our RTMs, again are, physical counts of the movements of goods over a distance for the tonnage, and that's up 15%. So, both measures are not really impacted by the FX conversion.

Chris Ceraso - Credit Suisse

That wouldn't have had depressed the revenue ton miles relative to the amount of rate that you moved up?

Claude Mongeau

No. The revenue per revenue ton mile, it would but not the RTMs versus the carload.

Chris Ceraso - Credit Suisse

Okay. Alright, thank you.

Operator

Thank you. The next question is from Jacob Bout with CIBC, please go ahead.

Jacob Bout - CIBC

Good afternoon. I had a question on press renewals. You talked a little bit about pricing going into the second half of the year, how much has been of your book has been re-priced and just, how the customers are responding? Are you seeing a little less pushback with the rebounding economy?

J.J Ruest

A high percent of it is already put to bed. I won't provide specific numbers and the, obviously the customers are still coming through the recession. They are the early days of the recovery. They too are putting price increase to their own markets some of them are very significant like you can seen in the coal market some other market maybe early days of changing their price, so, I mean it's really get down to the value we created with we will compete with and right now we are going to, we are able to get price increase for instance in the range of the 3.5% for the guidance for the end of the year as Keith has provided in the document.

Jacob Bout - CIBC

Okay, and my next question that would be on the flooding that we've seen in Western Canada, maybe talk a little bit about how that impact of the second quarter and then how does that change your outlook as far as grain volumes going into 2011?

Keith Creel

While on the grain and flooding in Western Canada, obviously, the seeding was less this year, number one, number two, the carry over from last year's profit to the next year's profit is higher because wheat board has not been able to sell us much of it's product as its first stock and I think in the last winter and last spring.

And then when you add to that our desire with our newer schedule grain service too already start early this year with our program, we think that for the next six months we should be all in and we should be able to be close to what we did last year on the volume. While when we get to the second half of next year which is sort of second half of the crop then it was well let's see the impact of the fact there is to be less crop coming in the [bin] this fall. So, short-term impact, this year limited, but we will see a impact next year.

Claude Mongeau

I would just add to that Jacob obviously, wheat price is going up; it's not just Canada having less production but also drought in Russia. So, with wheat prices been up the fact that the wheat board have available carry to sell into the fall should help cushion the impact of the lower production for 2010 but J.J says, the early part of 2011 is when we should see lower grain volumes.

Jacob Bout - CIBC

And as far as the second quarter is concerned was there any impact with your competitor's mainline product?

Claude Mongeau

No. From an operation standpoint, maybe Keith you want to explain what we did to help CP but for us it was not the nearly an impact like it was for CP.

Keith Creel

Yes, not a material impact to us at all and in fact we work closely for CP too, allow them to continued service taking detour trains, probably upwards of close to ten days over our mainline out in Alberta going though Edmonton to Winnipeg and a couple of other routes that they run that certainly we'll work close if they have been allowed to them.

And I think at the end of the day, they would say that and they have told us this hopefully help some recover their network which at the end of the day is good for the industry and get for our relationship and yet for the all the freight that we interchange together and as we work together on a go-forward basis. Someday that you maybe on the other foot so we've always tried to approach it from that respect, we're not going to kick somebody when they are down, there are our partners we're going to help them if such is the case.

Jacob Bout - CIBC

All right. Great, thank you.

Operator

Thank you. The next question is from Ed Wolfe with Wolfe Trahan. Please go ahead.

Ed Wolfe - Wolfe Trahan

Hi, good afternoon.

Claude Mongeau

Hi, Ed.

Ed Wolfe - Wolfe Trahan

Can you break out the reported yields, the revenue for carloads in terms of the impact from price field mix and FX?

Claude Mongeau

On the price, we have got 3% price increase that's when you take into account that we still have some RCF, some grain legacy. On the fuel we've got 4%, revenue came in from the fuel surcharge, a change in the WTI and the Highway Diesel and on the volume, we got 15% as we mentioned earlier are related to RTM and then there's the last 4% which comes from other revenue. The revenue which is not rare therefore does not contribute to the RTM, but never the less it's only becomes revenue for us, they are vessel operation dock, [ultra port] and trans load and that generated an increase of 4% of the total 26 of that single adjusted basis that we talked about.

Ed Wolfe - Wolfe Trahan

But if I want to look at the total carload yield down 9.5% year-over-year and prices out of three and fuel is at four. What's the impact of FX and mix to get me to the negative 9.5, what am I missing here?

Keith Creel

I think you should better look at it from a RTM stand point as because from a carload stand point, you have a huge mix impact from the short haul moves of iron ore that are up on a significant basis on a year-over-year basis, so I think if you take the 26% revenue growth and you break it down on a per RTM basis, that's the best place to look to.

Ed Wolfe - Wolfe Trahan

Okay, so I guess that the answer is that there is a big impact from mix and we got to think about the other direction.

Claude Mongeau

That's the different between a carload and RTM.

Keith Creel

And we'll be happy to help you further on an offline basis, but I think that RTM better gauge of volume and how to break down the key pieces of revenue growth.

Ed Wolfe - Wolfe Trahan

Fair enough. Claude, when you think about the operating ratio, seasonally there is not a reason why third quarter should be worse than second quarter, is there anything that you can think of other than a sudden change in demand or something like that?

Claude Mongeau

Well, take the good and bad that comes to you in the quarter, It's tough to predict what the third quarter will be until it's done, but there are no major differences between Q2 and Q3, the more important driver is that would have a seasonal impact our winter, our capital program and those aspects are not very different from Q3 to Q2.

But in the second quarter we had a tremendous amount of growth and we are accommodating that early phase of growth has very low incremental cost because we have the available capacity now. Our ability to continue to sustain this level of low incremental cost diminishes over time and that should start in Q3 and Q4 of this year.

Ed Wolfe - Wolfe Trahan

Are there any signs yet of slow down in export net coal or export any of your products at this point?

Claude Mongeau

Coal is holding up in the West Coast and Canada.

Ed Wolfe - Wolfe Trahan

When you say holding up, is there, is it strengthening, kind of doing what it's being doing or is it slowing but it's still strong? How do you classify that?

Claude Mongeau

I'm looking at the at the advantage of our customer of divine and within those advantages we keep than low which is our job and therefore we are moving everything they can make -- as they can. The answer is not really seeing any slow down, in fact there is good growth in this market.

Ed Wolfe - Wolfe Trahan

Okay and are you hearing from customers anything about inventory one way or another, or whether it's above normal levels, whether there is restocking going on? Any concern about that from anybody that they do not have enough inventory or that they are going to need less inventory going forward, either way?

Keith Creel

We have seen a lot of inventory replenishment in the first six months of the year and we believe that unless there is a contraction in the economy that continued demand should be helping our customer continue to drive volume going forward. There is obviously a lot of chatter end and it's tough to call whether demand will falter or whether other issues will creep up and if the people will have to trim production and start to be more cautious about inventory. At this point in time we don't see that and we are hopeful that the balance of the year will continue on that pace.

Ed Wolfe - Wolfe Trahan

Last question, just in terms of the CPU revenue that came across your track, where do we see that revenue show up and how much of that was in the quarter?

Luc Jobin

It's not a large amount and it's an expense recovery.

Ed Wolfe - Wolfe Trahan

So, it's contra expense basically?

Luc Jobin

That's correct, I believe yeah.

Ed Wolfe - Wolfe Trahan

Okay. Thank you.

Luc Jobin

Thank you.

Operator

Thank you. The next question is from Walter Spracklin with RBC Capital Markets. Please go ahead.

Walter Spracklin - RBC Capital Markets

Thanks very much. Good afternoon everyone.

Claude Mongeau

Hey Walter.

Walter Spracklin - RBC Capital Markets

Just two questions really here for J.J, you mentioned the other revenues that had a really nice spike here up over 30%, almost 40%. Can you talk a little bit about the sustainability of that kind of increase? I know that in the past you have been running back in 2000, through the years you have been much lower than the 250 run rate you are getting now. Is 250, the right rate to run that forward on a quarterly basis now?

J.J. Ruest

You are referring to 50 of I didn't get the begin of the question other revenues. Other revenues for us I really in large part related to the carload revenue when carload goes up these other revenue tends to follow it, because they are linked to it like iron ore, automotives and transport activities and some freight forwarding. So, right now maybe because of the [hollow] they realized and how if they are related to iron ore they were significantly higher.

Iron ore right now frankly is running very, very strong and maybe there is another 10% iron ore that we could see, that is if the mine can actually run at those rates.

Walter Spracklin - RBC Capital Markets

On a more normalized basis, is that closer to that's lower than the 250 I guess?

Claude Mongeau

I think on a normalized basis going forward we should see other revenues subject to iron ore continue at this phase or in that range.

Walter Spracklin - RBC Capital Markets

Okay.

Claude Mongeau

But on a year-over-year increase, we are not going to see a 40% increase going forward.

Walter Spracklin - RBC Capital Markets

Okay that's great. Second question here also for J.J, there is a question on pricing and did you reference how much you have booked for 2011 given your current contracts that you have already negotiated so far?

J.J. Ruest

No I did not. We are not providing that specific information publicly.

Walter Spracklin - RBC Capital Markets

How about in terms of your average length of contracts still around two to three years, is that a first payment?

Claude Mongeau

We have the whole range, just a one year contract, two year contract, long-term contract, when it's valuable. The length of the contract it's maybe at this point slightly drifting up and that's because there will be reason to do that, if the customer is making major capital investments and the likes.

Walter Spracklin - RBC Capital Markets

Okay. All right. Thank you very much.

Operator

Thank you. The next question is from Tom Wadewitz with JPMorgan. Please go ahead.

Tom Wadewitz - JPMorgan

Hi. Good afternoon. I wanted to ask another question on the other revenue which I guess you indicated that's going to go keep at a pretty strong pace. Does that tend to be similar to the overall margin or is that a lot lower margin, how would you think about that?

Claude Mongeau

Actually when we look at this other revenue we also track thanks to our pricing for that, we track volume how much is volume related, how much -- same way as we manage all the business, we also look at operating ratio. The operating ratio for this other revenue in total is not as the same level as of the railroad but at the same time the capital investment in this other activities is quite different. So, they are different business, they are as profitable but they are not the same type on the capital investment.

Keith Creel

In these our passenger revenues for instance, (inaudible) revenues, that other revenues is all other revenue and some are asset-intensive, some are not asset-intensive. I think they are on different basis than the normal rail revenues.

Tom Wadewitz - JPMorgan

Right. So it's different type of revenue obviously, but it's not going to be accretive to OR. If anything that would be a slight drag under your OR in the quarter having that big move up in other revenue?

Claude Mongeau

Yeah. It would be actually.

J.J. Ruest

Yeah.

Tom Wadewitz - JPMorgan

Okay. Let's see in terms of the per worker cost, I know it gets tricky to model because you got like credit, you got currency and you've got stock-based comp and other things, but how would you look at that going forward in terms of the year-over-year change in per worker comp and benefits for like third quarter, fourth quarter?

Claude Mongeau

I think you said it yourself, Tom it depends a lot on stock-based compensation and a lot of other moving parts. I think the important point for you to remember is other than those volatile item, which are very difficult to predict, but for which you have good guidance. a dollar up on the stock price since the adding of 4 million and 5 million of stock-based compensation and the other sensitivity that we disclose and inform you about the other pieces if wage increases in the range of 3% and whatever our workforce in addition will be going forward.

Tom Wadewitz - JPMorgan

Right, okay, great, thank you for the time.

Operator

Thank you. The next question is from Cherilyn Radbourne with TD Newcrest. Please go ahead.

Cherilyn Radbourne - TD Newcrest

Thanks very much. Good afternoon. I wonder if you could tell us how many train start you added in the quarter, and just have that compared to the 15% increase in RTM which you accommodated in the quarter, and give us some sense of your ability to add volume to your existing inter-middle and merchandise train recognizing that I'm asking to make a generalization there as it is going to varied by corridor?

Claude Mongeau

Train starts up about 7% with the volume that we saw so quarter-to-quarter. So, like the storing a lot of that volume and system train, train linked up, train load up significantly. And the second part of the question was how much more, is that?

Cherilyn Radbourne - TD Newcrest

Yeah. How much capacity do you have to continue adding cars to your existing intermodal and merchandised train starts?

Claude Mongeau

Well, just looking at the averages, and there is -- this is not a perfect sign, but effectively you got a 10,000 flip rail road and your average train link to 7,200 feet, I mean that tells you that in some corridors it will be more, quite a bit more in some corridors. I mean it's probably the most restricted, for the most constraint corridors and constraint probably is not the appropriate word, I'd say at least 20%.

Cherilyn Radbourne - TD Newcrest

Okay, thank you. And then for J.J. I think you made some references to this in your prepared comments, but you referred to sort of a trail to Analyst Day in the steel industry if you could increase your market share by being a bit more flexible in terms of your car order and lead times. Can you just kind of speak to the earlier results there?

J.J. Ruest

Yeah. The early results are positive. I mean like maybe other, like other rail road our market shares some of the inbound-outbound what goes to steel mill is quite limited. The -- when you look on the outset of a steel mills mostly truck is close to rail, so it's not so much of a question whenever the steel mill are running at 65 or 75% to operating range is more of a question, and we respond in time in our products. So we've actually reduced lead time for a steel mill to order a car. We'll call those shorter lead time, the guarantee car holder process.

We're also -- we've mentioned a lot of us focus on our first mile-last mile, in that case the first mile and yes we've gained points of share out of steel mill when it comes to seeing which is the trucking competitors.

Claude Mongeau

Its still early days but I can tell you one thing. Customers are trying out and it's a positive sign. So if we can respond with flexibility hopefully overtime they will trust us with more of their business.

Cherilyn Radbourne - TD Newcrest

Okay, thank you. That's all my questions.

Claude Mongeau

Thank you.

Operator

Thank you. The next question is from Ken Hoexter with Merrill Lynch. Please go ahead.

Ken Hoexter - Merrill Lynch

Great. Good afternoon. Just coming back to the yields revenue per carload if I can for a second, intermodal and coal were so robust including the currency relative to some of the others that you noted had mix. Is that because coal is more in the U.S. and therefore you're just looking straight up or were there some contracts that got renewed. Just wondering why the large differentiation is there.

Keith Creel

Its all mix related, distance of hull, more business for one account versus the other account. So it's all about mix, mix of customers, mix of length of hull. All contracts are renewed with some increase and it's about the mix of business.

Claude Mongeau

We've been on an effort to price to the value of our services for many years now and so by now we tend to have our pricing guidance and there much less variance around that 3 to 4% price and so sometimes if we have a little bit more opportunity because we create value it might be on the upper end or slightly higher than that. Other times when customers have difficulty or the competition with the alternative is a little tougher, we might be a little bit at the lower end or slightly below but our pricing is in that band of 2 to 5% with very few instances above that.

Ken Hoexter - Merrill Lynch

Wonderful. And then if I look at the coal, was that, something like that, maybe more met coal that you've gained. Can you talk a little bit about that?

J.J Ruest

Actually this quarter, the second quarter we've actually seen an increase in both met coal in Canada as well as thermal coal in the U.S. Both markets have generated for us increase in volume and in our Canadian coal market you also see into that buried into those results petroleum coke which when we publish coal, there is also some pet coke into that and pet coke from Canada comes from basically Fort McMurray.

Ken Hoexter - Merrill Lynch

Wonderful. J.J. when you were going over your review, I thought you said something about 3% on same store sales and then you threw out a 4%. Was that currency adjusted for that 3%?

J.J Ruest

The difference between the 3% price increase on same store and a 4% is, if we were to normalize, if you were for the Canadian regular grain which right now in the second quarter we had a 7% decrease versus last year as well as the fact that we do have some legacy contract that goes back to acquisition of a railroad that we did over the years which are related to RCF which obviously now are negative and eventually this index will turn vastly positive. Its really 4% when you take out RCF and grain but it's really because they are in the portfolio. It's what it is. It is right now 3%.

Ken Hoexter - Merrill Lynch

Wonderful. And then in the casualty line it was obviously an improvement from last quarter. Is was obviously an improvement from last quarter. Is there anything in there other than Keith's improved operations? Any actuarial gains or anything in the quarter?

J.J Ruest

Nope

Ken Hoexter - Merrill Lynch

Okay. And then last question, volumes. It sounded J.J. when you were going through the numbers that you were feeling pretty good about where things are going. I just want to understand if that was just kind of as you looked toward peak season or this kind of even the economic environment beyond that and around that that you're still feeling the strength continuing.

J.J Ruest

When we look at our weekly carload we cant quite necessarily relate to all of what we will read in newspapers because we are still moving very strongly the overseas business, the domestic business rolling up, the manufacturing sector, all of it seems to be holding up. Our customers on the overseas side, I met a couple of those recently. I'm feeling very good about the third quarter because already we're in late July. So, we already have a month and what's coming at us in August is obviously already on the dock, somewhere in China willing to be coming in. So I mean they have visibility to that. So, the question is really toward the fourth quarter and then we will see in the fourth quarter. I mean fourth quarter is a little off in terms of some of the things we'll see, while (inaudible) putting us to what happened there.

Ken Hoexter - Merrill Lynch

Great, I appreciate the time. Thank you.

Operator

Thank you. The next question is from Scott Malat of Goldman Sachs. Please go ahead.

Scott Malat - Goldman Sachs

Thanks. I wanted to ask a little question about intermodal. You talked about the surge. I know Prince Rupert has its own dynamic but really just trying to figure out what's driving the kind of intermodal growth we're seeing across the industry. Can you help us think through the factors here? How long does the inventory restocking provide a tailwind? Are there shifts from trucks accelerating for any reason? Are there certain categories of goods within intermodal that you think are really driving some of the outside growth?

Claude Mongeau

The import is mostly related to the economy in North America and Canada and the U.S. Vancouver has seen a record in June all in. We have seen a record. Rupert is combination mostly U.S. market and therefore potentially share related as opposed to economy related. On the East Coast, of CN, Montreal, and Halifax, it's not really share with it. It's kind of steady in terms of what some of these customers are seeing.

The export business is actually up going to West Coast because there is more containers available. We could have seen an export business of Canadian goods in the first quarter but there weren't enough container coming in to create a capacity for containers is going out.

So, now that we have this, Tsunamis of (inaudible) containers that came in May and June all the shipping line models containers back to the China. Either they are paying some of them empty, or ideally they want to get some freight into it with the Canadian manufactures and all that. We're talking pulp, lumber, grain crops and the likes are happy to try to get a deal to shipping lines to put some goods than going back.

Domestic freight, different story. We compete with truck. Truck market has capacity issues, cost issues and this is a place where our product may make maybe as much of a difference on how we fare as opposed to the overall market strength itself. We've put a lot of focus on improving both our domestic and overseas product and our customers are reacting positively to that better products.

Scott Malat - Goldman Sachs

Alright, that's helpful. Thanks. And just as another one, just maybe we haven't asked a while about the export potash opportunity. I know it's not for a while in terms of when things come up but what do you have the capacity for? What do you need to do to increase capacity? And maybe just touch on the overall opportunity of export potash?

J.J. Ruest

Without specifically talking potash. We have export capacity for a lot of products, whether it's manufacturing and maybe now wants to go west, and west like (inaudible), Vancouver or Rupert. Our rail line in our view are vastly underutilized and I think Keith can probably comments better than me on that. But we do have a lot of network capacity to move a lot of stuff going west. After that, it's the question of locomotive, which you buy as you need them and people which you hire as you need them.

And last mile activity in this instance. People have to, often it's the water front capacity, that's the bottom nick, whether it's the terminal in Vancouver or to new terminal in Rupert and so we will be there to accommodate growth as it comes in all those bulk commodity. We feel privileged to have access to both Vancouver and the Port of Prince Rupert in terms of long-term growth.

Scott Malat - Goldman Sachs

So there's nothing specific you need to export potash specifically?

Claude Mongeau

No. Because, typically export potash moves in customer cars and we have the rail line capacity. The issue is terminal capacity and where will the customer send the business.

Scott Malat - Goldman Sachs

Okay, thanks.

Operator

Thank you. The next question is from Jeff Kauffman with Sterne Agee. Please go ahead.

Sal Vitale - Sterne Agee

Hi, good afternoon Sal Vitale on for Jeff Kauffman. I have a question. Just looking at the incremental margins, I calculate the incremental margin for the second quarter was about 74%. Just looking at the expense line items, you talked a little bit about labor earlier. What about like purchase services and for example, equipment rents? I see purchase services down 1%. So FX adjusts probably something like up 5, 6, 7%. Is that something that's -- a level that's sustainable given the carload growth of what 27% and RTMs up 15%? How should we look at that for the second half of the year?

Claude Mongeau

Yes. Well, specifically on purchase services your right. Actually we do an FX adjustment for the second quarter, that's actually up 5% and as far as the balance of the year is concerned we feel pretty good. Again some of these things are moving step functions but we feel that we've got the capacity and we can absorb some additional volume without necessarily seeing a proportional increase in our costs. So we'll have to see how the business gets layered on but we feel that's actually not a bad run rate for us.

Sal Vitale - Sterne Agee

Okay, does that also apply to, for example, equipment rents?

Claude Mongeau

Equipment rents actually was quite favorable. We were looking at an improvement at 6%. Now I think that one maybe more difficult to keep at that level. We'll have to see but I think that may be a little tougher there.

Sal Vitale - Sterne Agee

Okay, and then just following up on labor as you spoke about earlier, did you mention what headcount levels we should expect for the second half of the year?

Claude Mongeau

We said we will continue with, subject to growth going forward we will continue to have higher running trades inline with business volume and in the other categories replace attrition but try to continue to gain productivity. So I think the second quarter performance which add a 3% increase in running trades and a 1% increase in the workforce overall is not a bad model on a go forward basis.

Sal Vitale - Sterne Agee

Okay, thank you.

Claude Mongeau

Thank you, very much.

Operator

Thank you. I would now like turn the meeting back over to Mr. Mongeau.

Claude Mongeau

Well, thank you. Thank you all for taking your precious time to listen in to our results. We hope you're satisfied and that we are closing the day, which was a good day on a good note and we look forward to see you on this call again at the end of the third quarter.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time. And thank you for your participation.

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Source: Canadian National Railway Q2 2010 Earnings Call Transcript

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