Canadian National Railway CEO Discusses Q3 2010 Results - Earnings Call Transcript

Oct.27.10 | About: Canadian National (CNI)

Canadian National Railway Corporation (NYSE:CNI)

Q3 2010 Earnings Call Transcript

October 26, 2010 4:30 pm ET

Executives

Robert Noorigian – VP, IR

Claude Mongeau – President and CEO

Keith Creel – EVP and COO

J.J. Ruest – EVP and Chief Marketing Officer

Luc Jobin – EVP and CFO

Analysts

Scott Group – Wolfe Research

Bill Greene – Morgan Stanley

Jason Seidl – Dahlman Rose & Co.

Cherilyn Radbourne – TD Newcrest

Michael Weinz – JP Morgan

David Newman – National Bank Financial

Chris Ceraso – Credit Suisse

Walter Spracklin – RBC Capital Markets

Tim Axtell [ph] – Banc of America

Gary Chase – Barclays Capital

Benoit Poirier – Desjardins Securities

Fadi Chamoun – BMO Capital Markets

Jeff Kauffman – Sterne, Agee & Leach

Operator

Welcome to the CN third quarter 2010 financial results financial results conference call. I would now like to turn the meeting over to Mr. Robert Noorigian, Vice President Investor Relations. Ladies and gentlemen, Mr. Noorigian

Robert Noorigian

Thank you for joining us for CN’s Q32010 financial results. I would like to remind you again about the comments that have already been made regarding forwarding looking statements. With us to today is Claude Mongeau our President and Chief Executive Officer, Luc Jobin – Executive Vice President & Chief Financial Officer, Mr. Keith Creel, Executive Vice President & Chief Operating Officer and J.J. Ruest – Executive Vice President & Chief Marketing Officer

After the presentation we'll take questions from those of you who are listening on the call. Could you please identify yourselves when you are asking the questions in order to be fair to everybody that’s there, could you please limit yourself to one question with one follow up. It is now my pleasure to introduce Mr. Claude Mongeau, our President and Chief Executive Officer. Claude?

Claude Mongeau

Thank you, Bob. And thank you to all of you for joining up on this call. We're very, very pleased to announce our third quarter results. They are good results. We are pleased that we were able to drive a significant volume growth and significant top line growth. If I measure it on constant currency basis, our revenues are up 18%.

J.J. will give you the contour of that growth later, but pretty across the whole book of business we've been making inroads and taking advantage of the economic recovery, but we're also making inroads in terms of our ability to serve our customers and grow faster than what the economy would give us by getting more of their discretionary business.

So, that's solid growth that has been accommodated as low incremental cost. Keith and his team are doing a wonderful job to handle the business creating flexibility to improve service but also maintaining our high level of efficiency and continuing to make progress in terms of productivity and this is what helped us drive a very good operating ratio, our third quarter operating ratio was 60.7 which is 2 point improvement over last year.

In terms of earnings, solid earnings up 25 –27% on an adjusted basis, Luc will give you some of the details of how we were able to drive this performance, but this is the third quarter in a row where we're able to show leverage and show solid performance on an earnings standpoint and free cash flow standpoint.

Year-to-date your – that's $938 million of the free cash flow and that’s despite the fact that we have made a contribution to our – voluntary contributions to pension plan which Luc will explain to you in a minute. So, clearly from a financial standpoint very solid results and I'd like to say just a few words to give you an update on what we're trying to move forward in terms of our strategic agenda, with a particular emphasis on service excellence.

There was a lot of milestones achieved during the quarter in terms of supply chain collaboration you may have followed us that we've been able to finalize the basically across Canada (inaudible) all of the major Canadian ports now have a supply chain agreement. And I'm also pleased to report that we have service level agreements with all of the key container terminal operator in all of those major ports across Canada.

We're leveraging the value that comes with those service level agreements in terms of visibility and end-to-end focus one box at a time. We're fixing issues and addressing bottlenecks on an on-going basis pretty daily with the benefit of these score cards that we've put together with our partners. And it's really helping us to improve our performance in terms of the overseas business you've seen the results of that over the last several months, that’s again the third quarter and J.J. will give you the detail. We have very good growth in terms of our overseas business.

Our end-to-end approach is also showing significant benefit in the bulk side. We've had good performance in terms of our new scheduled grain performance but also very, very good performance in moving Canadian coal to the West Coast in record level. So, we call it our mine-to-shift supply chain approach and it's clearly paying dividends.

In the merchandise side, similar story, a couple milestones we've introduced our new car order process which givers flexibility to our customers, we are using that flexibility to gain opportunities one car load at a time whether it's in steel or forest product we are able to respond quickly and have higher fulfillment rate which is helping service to our customers but importantly it is helping CN capture more business and given that every carload counts it is helping us having the top line grow little faster than what the general economy would have given us.

So all of these service initiatives are core to our strategic agenda, we have said we would be working on those when we met with you in – at our Analysts Meeting in May or early June. And we are delivering on them one step at a time. And it's a positive story over all.

With that, I will turn it over and Keith will give us a run down on our operations.

Keith Creel

Yeah, thank you, Claude. Let me start by recognizing and thanking the best operating team in the industry that I'm honored to lead again for delivering a strong operating performance this quarter, you know, since Cliff Paul laid out our CN 2010 Vision three quarters ago, this team continues to leverage our operating model focusing on delivering meaningful results which we're basing on service innovation, and point engagement, growth absorption, and a constant pursuit of safety excellence.

The financials you're looking at provide a strong case, this approach continues to deliver. So let me take a couple of minutes to share few of the details that we’ve been up to.

Speaking to the productivity metrics front that we report on each quarter, we’ve again achieved gains in virtually every aspect of our operation. To put in perspective since the year-end 2008 during ‘09 and' 10. We've driven a 20% improvement at CN from a 25 mile an hour railroad rail road to consistently knocking on the doors at 30 miles an hour railroad.

We've driven over 15% improvement in car velocity from 185 miles to 214 miles per day on every car we handle. And the most critical validation point that I want to leave with each of you is to our operating performance this year, year-to-date we've done all this while maintaining or improving our metrics absorbing a growth rate over 12% over 2009 volumes. Moved on our eco-friendly trains that are safer and longer and heavier. (inaudible) blocking and tackling day in and day out with our – executing our operating model.

And I'm happy to share with JJM with the audience that in 2010 we've involved that same tenacity and focus on improving customer service and earning additional market share one carload at a time.

To ensure the success, that story continues we have to continue unabated in CN – we do it by making smaller targeted investments to support our growth and service performance like the NL-32 locomotives DP-equipped, higher horse power, fuel-efficient with the latest technology in 2010. We've retrofitted others.

We currently have 35% of our locomotives equipped with DP and we're pushing to 50% by the end of 2011. So you combine that if you are looking at marketing forecast 6 to 12 months out with our attrition and we'll be in solid shape to handle the business.

As I mentioned, let me make a couple points on DP side. These locomotives continue to allow us to run safer, longer trains especially as we look forward to the cold winter months that lie ahead in the years ahead, they also allow us to further leverage our investments in long sidings running longer and heavier trains, currently which are not possible without these concepts..

On the car side, we purchased just under 2000 new rail cars this year to support growth and the iron ore, steel, coal and forest products markets and in certain cases where we've had periods of excess fleet we're strategically storing cars to provide recoverability and to improve our ability to respond to spot opportunities like those we converted in the volatile steel market during 2010. Another key resource we’re carefully managing is train crew base, we have roughly 6,000 employees, over the next five years just under half of those will retire.

Keep in mind that it takes six months to recruit and train a new conductor so it is critical that we get this right. We're relying on the volume forecast and we do so by the resource tool that we’ve deployed earlier this year, precision planning process. We respectively take the forecast, we compare it with attrition on the marketing side and it put this where we need to be from a resource standpoint. These steps combined with our tentative labor agreement will ensure that we are prepared to protect the service.

By the way I'll comment that I'm excited about that tentative agreement we recently reached for the conductors in Canada, it's largely a status quo agreement in nature but it does provide a mechanism for us to work together in scheduling issues which we hope ultimately will be good for CN and for our running freights employees on a go forward basis.

On the customer front, our daily operating metrics are being rounded out with suite of customer centric metrics designed to assess performance from our customer's perspective. These measures include switching performance, car supply, traffic left behind, our car to truck times, terminals to terminals to terminals and ageing of our containers at ports.

And finally as an excellent example of pursuing a more collaborative approach with our employees in partnership with our dispatch officers and our employees that run our dispatch centers we’re implementing a dispatching excellent initiative.

Their mandate is simple, it is to identify ways to drive up train service performance doing it with process improvement collaboration and some targeted investments.

I trust that gives you a good flavor of some of the key areas of innovation at CN that we are pursuing that will allow us to continue our operating story, a success story that we’ve produced and with that I'll turn it over J.J. to review the top line.

J.J. Ruest

Well, thank you, Keith. That's operation excellence. I'd like you now for you to join me in looking at overall revenue results on slide 10 looking first at the year-over-year results Q32010 versus Q32009. The quarterly results of this year are more than just economic recovery story.

It is time to see the dividend of our new supply chain initiative which are designed to help our customers to grow their business and position CN to handle a greater amount of their traffic.

Revenue growth for the third quarter was 18% on FX adjusted basis. To peel that off of an each element, 9% of that was rail revenue RTM we’re up 9%, carloads, we're up 18%. 3% came from same store price from same store sales. Another 2% came fuel surcharge and remaining 4% came from non-rail business and some positive mix.

On the sequential basis third quarter versus second quarter of this year, the volume declined by 1% in terms of RPM while they increased 2% in terms of carload.

Now, if you want to join me on the next page, I’m looking at the business-by-business again emphasizing the revenue on an FX adjusted basis. Petroleum and Chemical up 14%, the Canadian recovery in chemical production was initially behind that of the US, but seems to have caught up.

Metals and Minerals was up a strong 29%, a reflection of our ability to work with our customers, we have strong iron ore volume and we have truck market share gain in the steel industries. Automotive, was also a strong 26% growth FX adjusted.

Strong production from the CN served plants as plant as well as new supply chain focus, for example, ground and entry dwell time where we track dwell time performance from both ship discharge in the case of Halifax and from the assigned plant release from the plan (inaudible).

Forest products was up 8%, there was no real movement in US (inaudible) and we do not expect that that to move very much. However we have strong partnership with our forest product customers as well as our shipping line to capitalize on their China export boom in carloads and containers of lumber and pulp.

Coal, revenue was up 31% another strong performance. We have strong demand for coking coal, ex Rupert and Vancouver, we have strong demand for export terminal coal ex US Gulf, and we have some replenishment of utilities at entry level in US.

Grain was up 10%, Canadian grain was up 13% on strong export mainly of Canola and peas and US grain was up 5% mainly on strong export of soya bean and corn.

Fertilizer was up 9% mostly on potash, the dealers’ inventories are very low order and the best is yet to come in the fourth quarter for the fertilizer stories.

Overseas intermodal was up a strong 28% due to a strong west coast import and export trade as it is evolving very strong export story in overseas.

Domestic intermodal was up 10% and improvement that came mostly from our direct retail door-to-door product and again on that the best has yet to come.

Other revenues came – was up 28% primarily due to Great Lakes Fleet and dock operation which are part of in-house R&R supply chain business unit which has been extremely well in 2010.

Now, let's go to the brief outlook on Page 12. So far this quarter our carloads volume has grown 11%. And we need to keep in mind our comparable from last year to be improving and then over last year – the recovery was to come in the fourth quarter.

If you look at the three broad segments, first looking at manufacturing, we have additional fleet that position – that will come in line during the fourth quarter which will support our on-going truck market share initiative in steel.

We have a continued focus on serving the shale gas activities which in case is mostly in western Canada and that will support our shipment of frac sand and drilling pipe throughout the coming quarter. The automotive production level are expected to increase by about 10% versus 2009 in keeping with the momentum that we have acquired so far this year and I think many of you have heard the good Ford Motors result yesterday and that bodes well.

On the bulk side, although the Canadian grain harvest is smaller and late we see very strong overseas pricing for those crop which are actually increasing sequentially out of the west coast above the third quarter of this year, market for export coal remained very positive we view our strategic position out of port of Prince Rupert as being something that will be very useful for us in the midterm.

A slow start to this fall fertilizer in September has actually pushed forward the demand into the fourth quarter of this year, on intermodal the import fall peak came in early this year. It came – actually it started to come in and May and started to turn down around the month of the September imports as import are slowing down there is still a very strong push from BC export to look for vessel capacity back mostly to China. Claude has already mentioned our port supplies – port supply chain agreement with the ports and that bodes well also for future.

On my side I've been mostly focused on what I call a glowing box report which is the daily report that we produce for our terminal partners. Customers experience is not in port average dwell time. Customer experience is related to their own box that outside in view of (inaudible) service actually what tells us to create value for those actually paid crate.

In conclusion, we expect usual fourth quarter sequential slow-down, however, we also expect our bulk business and our internal business to be very strong in fourth quarter versus 2009 ending off a great year on strong note.

So I will turn this over to my friend Luc who will comment on financial side.

Luc Jobin

Thank you, J.J. Let me briefly review the financial results for the third quarter as was mentioned earlier by J.J. the revenues were at $2.1 billion up 15% and on an constant currency basis that was actually an improvement of 18% versus last year same quarter.

Operating income and net income were both up 21% and our adjusted EPS came in at $1.19 which is up 27% versus last year and on a constant currency that's a full 30% improvement versus 2009. Our third quarter operating ratio was 60.7, a 2 point improvement versus last year and our year-to-date operating ratio now stands at 63.6% which is a 3.5 points improvement versus last year.

Turning to page 15, our operating expenses came in at $1.3 billion and that's up 15% on a constant currency. We continue to have effective cost management throughout the quarter as our carloads were up 18% and our RTMs were up 9%. Fuel was a significant category where the cost came in at $249 million that was up 27%. This was mostly due to higher prices where the WTI was actually $76 during the quarter versus $68 looking back at the same quarter a year ago. We also obviously had higher volumes.

On the labor and trench costs the expenses came in at $437 million, that was up 7% and this is a result of an increased workforce by approximately 2.5% as we continue to adjust our manpower in line with volume and ahead of attrition. In fact our T&E resources were actually up 5%. We also had some higher wages and benefit costs during the quarter.

On the depreciation front our expenses were $204 million that was up 8% versus last year. This was mostly due to net asset additions, but we also had an increase in depreciation from the completion of our first phase of a Canadian asset depreciation study.

Now this study is done every three years and it is a comprehensive review of every asset category. This year we're having the benefit of much better asset specific information and this first phase covered a portion of our assets and resulted in an annual increase of approximately $20 million going forward in depreciation.

Phase 2 will be completed by the end of the first quarter of 2011 and while it's a bit premature, I would say that we do expect the results to have a similar impact as the first phase. So all in all we could see a potential increase in our depreciation from these asset studies to be into tune of about 50 basis points of operating ratio.

On the casualty and other costs, the expenses were $91 million and this was an increase of $40 million versus last year. Now, this increase was the result of two factors, the first one is, some of you may recall last year we booked a 20 plus million dollar adjustment – favorable adjustment which resulted from improved experience relating to our US legal claims. In addition this year, we have accrued about $15 million of environmental expenses as a result of our on-going review of these issues.

Turning over to cash-flow as Claude mentioned earlier our free cash flow was $938 million and that was $280 million plus improvement versus last year.

This was the result of a very strong operating performance in addition to the sale of non-course of division in Toronto in the first quarter to the tune of about $170 million and also some lower cash tax installments on the Canadian front probably for somewhere in the neighborhood of $250 million.

This was also partly offset by a voluntary additional pension contribution which we made in the third quarter in the amount of $300 million. And this was intended to improve our plants funded position. Now asset returns remain volatile and quite modest in 2010, however, the discount rate has actually continued to come down.

So if you actually just took the discount rate at the end of the year, which is what's going to determine the pension benefit obligation in our future cost, we will ultimately know what will be the liability and the future cost.

But just looking at the end of September, using the rates that were in place we can actually see the potential for an increase in our pension expense to the tune of about 50 basis points of operating ratio.

From the context standpoint we invested about $824 million in the year-to-date results and we expect to invest approximately $800 million in the fourth quarter as we continue to prepare our winter program. In fact we're looking at accelerating the delivery of some of our new high horse power and DP equipped locomotives to help in this respect.

Our stock buyback is 75% completed. And so we're up to 11.5 million shares which have been acquired at this point in the year.

Turning to the 2010 financial outlook, we continue to leverage the recovering economy and as our certainly our third quarter and year-to-date results indicate. We continue to see a gradual economic recovery unfolding albeit at a slower pace in the fourth quarter versus obviously the year-to-date performance.

Nevertheless we reaffirm our 2010 guidance as we believe that we have the scope to achieve an increase of approximately 25% in our 2010 adjusted diluted EPS over 2009 which was really 324. We also continue to see free cash flow in the range of $1.1 billion.

So we're going in to the fourth quarter with good momentum and good position to finish the year. Also we’ll be positioning the company for a solid winter program and a good performance in 2011. All of this should translate into some solid shareholder value.

And with that I'll turn it back over to you Claude.

Claude Mongeau

Well, thank you, guys. Just to wrap it up. I think we have a solid year in the making as Luc explained to you. We are taking every bit of advantage of the economic recovery. But this is more than just economic recovery. We're also very much delivering on our strategic agenda working with our customers, our supply chain focus is helping us gain market share one carload at a time. And if we continue to do this, I believe that the rail industry has a great future ahead of us with more and more people see the value of railroading in terms service, see the terms of railroading in terms environmental friendly and see the value of railroading in terms of costs for their transportation needs.

So, our challenge is to keep the service improving, keep the operational excellence and drive that combination to reward our shareholders over time.

With that, we'll be happy to take questions from the audience. Operator, over to you.

Question-and-Answer Session

Operator

Thank you. We will now take questions from retail phone lines (Operator Instructions) Thank you for your patience. We do have a question from Scott Group with Wolfe Research, please go ahead.

Scott Group – Wolfe Research

Hey, good afternoon, guys.

Claude Mongeau

Good afternoon.

Scott Group – Wolfe Research

So, Luc, question for you on the casualties side. I see that it's up a good amount year-over-year up against some tough comps. But if I look at it sequentially it's down pretty materially from where we were in first and second quarter. Is there anything on the reserve adjustments or actuarial side that that's keeping that number so low and if not is this 90 million a good run rate going forward?

Luc Jobin

Yeah, I'd say the $90 million is not a bad run rate going forward and so and I don't necessarily expect anything significant on that front in the fourth quarter. So that's kind of where we are. Yeah.

Scott Group – Wolfe Research

Okay, great. And then I have question for J.J. – you talked about some at least feeling – near term feeling very good about the bulk side with green and coal. I was wondering if you think that can continue into 2011, do you think you might lose some coal volume back to CT given their new contact with (inaudible) and then on the green side do you think green could be positive next year given the Canadian crop that's going to be down 10% or so?

J.J. Ruest

I think we feel very positive in some of the bulk business for the fourth quarter. Canadian grain is high priced. The crop is smaller and the positive the crop will be very well-known only come late November, December. But right now the product is moving very well and we have a very strong order much higher than the third quarter. At some point next year when it's first quarter, second quarter, eventually the quality will start to show an impact.

Also we are very positive about the fertilizer side, the potash, and eventually in North America the wholesaler, people are buying when they need it. I think we'll have a good push in October, November. And the next thing we'll see on the coal side we have a good start.

I think Claude mentioned a supply chain story that we have and our activities at both Rupert and in Vancouver is very busy with the mine that we serve. I think it's natural that Tech and the other railroad long term partnership because of physical location of those on mine in southern VC that was obviously we don’t serve. And you know what happened there is maybe something that's very logical.

Scott Group – Wolfe Research

Are there volumes that you expect to lose to – lose with Tech as a result of that contract?

J.J. Ruest

I think time will tell. But we think that maybe we're getting too narrow of a discussion, but time will tell. I don't know where that will lead us.

Scott Group – Wolfe Research

Okay. Thanks for the time, guys.

Operator

Thank you. The next question is from Bill Greene with Morgan Stanley, please go ahead.

Bill Greene – Morgan Stanley

Yeah, hi there, good afternoon. I'm wondering if we can talk just a little bit of clarification on the guidance. You beat this quarter, but you didn't raise the full year. So the obvious question is sort of what are you seeing in the fourth quarter that gives you pause that you don't want to raise the full year number?

Claude Mongeau

Let me handle this one. I think we're very well positioned to finish the year on a solid note. And at this point in time we didn't feel that changing our guidance was necessary, but we – as long as the economy holds up and we continue to continue deliver, we should finish on a strong note and as Luc said approximately 25% we have a little wiggle room around that.

Bill Greene – Morgan Stanley

Okay. If I look at kind of some of the metrics that we showed here on the operating side, there are it is obvious that you are the most consistent and strongest operator out there and you’ve had a lot of success since ’08 but recently we had it sort of topped out. Does this suggest we are hitting a wall or kind of is there a way to get to new level or how do we think about the evolution level from here?

Luc Jobin

I wouldn't say that we're hitting a wall. There’s still capacity left in the railroad. I just said you're getting to a point where last year with – very less, I guess less challenged railroad with much fewer boxcars and locomotives running around, we had some astounding outstanding metrics. We're laughing against those metrics.

There's still more to go and yes there is more we can do down the line as we continue to strategically invest in locomotive and make inroads with our unions that we operate on a more collaborative approach that we're pursuing.

Bill Greene – Morgan Stanley

So Claude, that is just sort – it is kind of circling back then. I guess what that says, is really the only way you're going to have a big beef is really got to be revenue. There's – it's – we've got tougher comps on the operating metrics and so revenue is really the game. Is that fair?

Claude Mongeau

I don't think it's fair. To be honest, we are leading the industry in terms of volume recovery by wide margin. So we've been operating in the third quarter and are operating in the fourth quarter at levels approaching 2008. So the fact that we are able to keep the operating metric that we have despite the volume growth on a cumulative basis over those two years, it's pretty stellar productivity and efficiency improvement.

So, we just got to regroup from here and as we accommodate – volume going forward with a view to having right trade-off between investing in service and flexibility and pushing on the efficiency front, you can CN driving the top line and being able to accommodate that business at low incremental cost.

Bill Greene – Morgan Stanley

Okay. Thank you, that’s very helpful. Appreciate it.

Operator

Thank you. The next question is from Jason Seidl with Dahlman Rose & Co. Please go ahead.

Jason Seidl – Dahlman Rose & Co.

It’s Jason, gentlemen. Just getting back to the guidance, what are you using for your continuing ops for 9 months in this guidance number?

Claude Mongeau

I'm not sure that – you mean in terms of EPF?

Jason Seidl – Dahlman Rose & Co.

Yeah.

Claude Mongeau

Whatever – I mean this is perhaps a better question to have off line. But, whatever we’ve reported in the first two quarters plus the 119 that we reported this quarter is what you should use as the first nine months.

And as I said, you know, Luc gave you guidance for the full year at approximately 25%, which is basically reaffirming what we have said here.

Jason Seidl – Dahlman Rose & Co.

Okay. I'll go back and take that off line then. Claude, you guys have done a lot with the points and everything else. How should we look at that going forward as a revenue opportunity for CN and how should we think about modeling that for 2011?

Claude Mongeau

The way you should think about that is this will underscore our ability to grow slightly faster and what the economy will give us as we discussed when we met in Chicago, you know, the evidence to me; you have to see it on a daily basis. I see the collaboration for instance on the west coast between the terminal operators in Vancouver and our operating team is nothing short of a totally new approach.

We're monitoring data in what it takes to come together terminal and railroad on a daily basis. So we are seeing issues. We have much quicker recovery. We are able to bring dwell times in terms of the time it takes for containers to stay on the dock down significantly. And more importantly because we monitor one box at a time as J.J. mentioned it's not just average. It's making sure that we don't leave boxes behind that become reputation killer.

And so if you improve consistency and you bring down the averages in terms of supply chain efficiency, eventually you get more traffic and you only need a few boxes more in what the economy would give you, and you do that consistently over time it adds up.

Jason Seidl – Dahlman Rose & Co.

Okay. Claude, Thank you. Real quick, the reported number in your – for the nine months in your press release says diluted (inaudible) but I doubt you guys are going to be guiding the $0.66 for 4Q. So could you help us out and clarify that a little bit?

Claude Mongeau

This is probably best handled off line. But you have to take out the special gains that we had during the year to get to an adjusted number. I think, if you call Bob, you’ll –

Robert Noorigian

You can call me afterwards.

Jason Seidl – Dahlman Rose & Co.

Will do, Bob. Thanks, guys.

Robert Noorigian

Okay.

Operator

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

Cherilyn Radbourne – TD Newcrest

Thanks very much and good afternoon. I wondered if you could speak a little bit about your discussions with customers and what they're telling you in terms of their inventory levels as we look forward to 2011. What kind of shape do you think they're in?

Claude Mongeau

I think we get to sample their inventory level. Obviously it's not a peak that it has been depending on the segment, depending on the segment there has been some rebuilding, proximity rebuilding but there is still ways to go in terms of, then you get down to commodities so fertilizer inventories is low, automotive I was looking at the dealers inventory by model type and by auto maker, you know, it varies, it is slightly up from where it was some auto makers are above the average, some are still fairly low.

So I think we – there's still room into this runway of rebuilding eventually slowly plus obviously maintain the demand, the market demand.

Cherilyn Radbourne – TD Newcrest

Okay. And my second question, I just wondered if you could comment on the collaboration agreements that you've negotiated and just who is leading that process internally? Have you developed standard template now and as you negotiate those agreements, how do you make sure that you protect the end operating model?

Claude Mongeau

Let me answer that. I think the way we are leading this is in Rugby style using a scrum, this is truly operations and marketing getting on the grounds, not just at CN, but when we meet with a terminal operator friends, it is down on the dock level, the people who are actually operating the cranes and the operating the terminals that we have to come together and agree on what metrics make sense.

So the answer to your question is it the scrum approach and by now we've done it enough that we actually do have a template and every terminal is a little different but effectively we're following the template out of the core ten measures nine or eight would be the same across terminal and then we have one or two that would reflect the specificity or some of the special issues that might creep in for one terminal at a time.

J.J. Ruest

If I may add. We have the similar engagement whether it is a bulk terminal, a container terminal or break wall terminal.

Cherilyn Radbourne – TD Newcrest

Okay. Thank you. That's all my questions. Next quarter.

Operator

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

Michael Weinz – JP Morgan

Hey, good afternoon. It's Michael Weinz in for Tom. Just wanted to touch base really quickly on other income. I was kind of surprised that it was so high in the quarter. Was there anything specific driving that?

Luc Jobin

No, I mean, interest switching revenue was actually – are you talking other income?

Michael Weinz – JP Morgan

Other income, yeah.

Luc Jobin

No, we didn't really have anything exceptional versus the last quarter– last year.

Michael Weinz – JP Morgan

But it was significantly higher than first and second quarter, so how should we think about that going forward?

Luc Jobin

This actually can be it's not a straight – it is not a straight projection, so it can be a bit lumpy, but by and large we do expect the number that you had in the first and second quarter to, you know, on average be about the right level.

Claude Mongeau

I think the best way to think about it is you probably want to average out the volatility and then take the average and that's probably a good indication of future other income.

Michael Weinz – JP Morgan

Okay. Makes sense. I was wondering, on the headcount side, how should we think about – I guess on volume and headcount, how should we think about seasonality going into fourth quarter. It looks like from a volume perspective, volumes are typically flattish fourth quarter versus third. Do you think you can get that this year and what would that mean for headcount as well?

Claude Mongeau

We're hiring mostly in line with attrition and then volume comes in to play but on a sequential basis, the volume between Q3 and Q4 is not going to be a significant movement. So we are – it is more what Keith was explaining to you earlier, we are trying to stay ahead of the curve so we looked out to our attrition six months into next year.

And because we have to train these people, you have to start getting them on board and you'll have some of that in Q4. So, I think that the Q3 shape of our work force adjustment is probably a good indication, more increase in – in T&E employees – where we are hiring basically replacing one to one.

In the other sectors we are able to get productivity so the increase is less pronounced.

Michael Weinz – JP Morgan

That makes sense. And just on the train starts and train length side, I was wondering if you can provide the year-over-year change because I don't think that was brought up in the operational highlights this quarter?

Keith Creel

Train start side year-over-year effectively 12% increase in business and train starts by about that 4%. What's the second part of the question?

Michael Weinz – JP Morgan

Train length?

Keith Creel

It's up in excess; it's about 6%, 5 to 6%.

Michael Weinz – JP Morgan

Great. I appreciate it. Thanks for the time.

Operator

Thank you. The next question is from David Newman with National Bank Financial. Please go ahead.

David Newman – National Bank Financial

Good afternoon, gentlemen.

Claude Mongeau

Hi.

David Newman – National Bank Financial

Just in terms of the pricing, or how did the grain reversal factor into your same store pricing?

J.J. Ruest

Regular grain represent I think it's 6% of our revenue.

David Newman – National Bank Financial

Okay.

J.J. Ruest

For the full year and that has changed – come in to effective every year on August 1st, you go – went from negative to positive for this year.

David Newman – National Bank Financial

Yeah, so there was a bit of positive factor, so that would have been played into the number for two to three months, correct?

J.J. Ruest

In relations to carload, the grain that we move into the third quarter.

David Newman – National Bank Financial

Okay. Just over all, are you – obviously in the truck competitive sector that you're in, we're seeing price increases even in things like LTL etcetera but – and you have got this CSA 2010 which is coming in fact for the trucking industry. Do you anticipate that you'll be able to take some price increases on the back of, I guess, price increases are seen – they are better being by the truckers and evolving, I guess, driver shortages?

J.J. Ruest

Most certainly, but in the trucking industry or the state of the trucking industry or regulation pricing and, you know, regulation you talked about is different between Canada and US

David Newman – National Bank Financial

It will have some effect for sure.

J.J. Ruest

It will have an effect to the extent that we have an exporter to U.S. truck market which has different behavior than the Canadian truck market.

David Newman – National Bank Financial

So, in terms of your negotiations, you're not seeing anything – any sort of – more inflation being built into your pricing so you're sort of sticking with the same store or sticking with the inflation plus kind of pricing?

J.J. Ruest

We're not going to go into specific guidance of what we're going to do next year in terms of price. But the current run rate that we have right now is in line with what we talked about, inflation plus pricing. So you're look at inflation, you look at the service that we provide and the better we are in some of these first mile and last mile in some market whether we are in some of these initiative. Of course we’ll take over another market. We will leverage that to the extent we can either price or volume or better things.

David Newman – National Bank Financial

Very good. Thanks guys.

Operator

Thank you. The next question from Chris Ceraso with Credit Suisse, please go ahead.

Chris Ceraso – Credit Suisse

Thanks, good evening, actually had a follow up in a similar vein on pricing and inflation. It does seem like in the quarter that pricing at plus 3 was not able to keep up with inflation if I look at your labor infringe and purchase services and materials they're rising at a faster rate year-over-year on an FX adjusted basis. How do you – is that something you expect to continue?

Luc Jobin

Let me challenge you a little bit on the inflation and actual fact that, I mean, the broad inflation is lower than that. And if you exclude, you know, factors like stock based compensation, et cetera, our wage increase is in line with about 3%, 3 to 3.5% wage increase when you include benefits and so our pricing has been generally in that range both this quarter and in the past.

Chris Ceraso – Credit Suisse

So the increase above and beyond that is mainly incentive comp?

Luc Jobin

It's a higher – larger number for the work force by 2.5 then you've got some of the incentive comp on top of that, yeah.

Chris Ceraso – Credit Suisse

Okay. But I mean, even if we think about it that way, that happens quarter-after-quarter, don't you feel like you're kind of losing some ground with your costs going up faster than your price?

Luc Jobin

May be we can take it apples to apples, when we measure price, maybe we measure in a fairly – our same stuff price increase is pure price that is 90% of the business really is – has fuel surcharge. In our price, we don’t have RCF or the indices which are the fuel components, fuel price is fuel price, fuel is fuel and when you look at our price, it is really just price, it is not – we don’t do very much index pricing, we don't do very much index business that's why 90% of the booking business is based on fuel surcharge.

Chris Ceraso – Credit Suisse

Okay. And then just one clarification, I didn't quite catch the comment from Keith about 6,000 employees over what time frame was that you expected to higher those people and was that equal to the number that you thought would lead through attrition.

Keith Creel

No, 6,000 is the base, So effectively T&E, train and engine employees, right now, we are up 5% year-over-year, so that run rate on a go forward basis, we are going to be trading out for the next four to five years the demographic model constant across the company, so we have to hire them ahead of time – keep in mind, not just the conductor that takes six months to train it is also the new engineers are trained at the same time and those conductors are replacing engineers as you pull those promote and pull them out to do their training for engineer certification, so it's to a degree you've got to manage both sides.

It is a 5%; it is pretty conservative number, pretty good job of doing it. We are making sure we keep the work force correct.

Chris Ceraso – Credit Suisse

So, that’s’ roughly your attrition rate and you are going to hire to replace on a one-for-one basis.

Keith Creel

It’s correct, plus that little advance to make sure we have at a time and we got them trained on some quality job.

Chris Ceraso – Credit Suisse

Understood. 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, Walt.

Walter Spracklin – RBC Capital Markets

From the service review panel the intra report that came out, it seems that they are going to be keeping an eye on the railroad industry at least on the Canadian side, up until 2013 and Claude, you have been doing a lot of things from – as you highlighted in the service initiatives front. Just trying to gauge and understand exactly what the initiatives are that you are going to provide and what they – how they might impact? But is there a risk to the increased levels of service that you are providing your customer, an increased risk to your operating ratio and if there is not, can you explain to me sort of why wasn’t there something that you would have done earlier or what is happening now that’s allowing you to be able to provide better service without it impacting your bottom line.

Claude Mongeau

I think you have to take this as we explained it before in the context of the natural journey that CN has been on. You would improve your basic service, schedule your train operations, you get the hub to hub velocity to a leading position. That’s what we have done over the last several years, once, you have achieved that you continue to have improvement potential in this regard, what is your next opportunity. Well, your next opportunity is to focus on first mile, last mile to get the switching window compliance, you know, improve on order fulfillment, you also bring to this the more end to end supply chain management approach, you reorganize the marketing forces and you give a slightly different mandate to your operating teams that will add to their operational focus a few more customer centric measure and that is the journey we have been on, a journey of constant innovation pushing the envelope in terms of service and operational excellence.

That's the journey we're on and we think we have a great opportunity going forward to not only maintain our operational efficiency, but to improve the product and grow the business that win our customers a little bit faster in what the economy would give us.

Walter Spracklin – RBC Capital Markets

Thank you. That’s a great color Claude. Just moving to I guess sort of question here. Your guidance before I think was around 27 to 29% for tax rate. You have been getting the benefit from a lower tax rate so that’s been helping your bottom line a little bit again this quarter in the 27 at 28% rate. What do we look at going forward? Is this is 27%, 28% tax rate going forward or should we model something higher?

Luc Jobin

I think it still continues to be in the 28 to 30% range. I mean, you know, we've been at the lower end of that. And we came in on the quarter of 27.6. So going forward I'd say, you know, 28, 29% probably a good place to be.

Walter Spracklin – RBC Capital Markets

Okay. All right. That’s my two questions. Thanks very much.

Operator

Thank you. The next is question from Tim Axtell [ph] with Banc of America, please go ahead.

Tim Axtell – Banc of America

Hey, good afternoon. If I can just clarify the – on the outlook just for a second. I know you said it was based off of 324 or 25% growth gets you at about 405 in earnings. And you have done 312 through the first three quarters that gives you $0.90 $0.93 fourth quarter with consensus up at $1.07. I know Claude you keep kind of just saying you want to talk about this later, but I just want to understand why the $0.14 below consensus, is there something going on in the fourth quarter when you compare to last year's fourth quarter so it would be a flat quarter relative to the pretty sizeable upside we've seen in the first three on a year-over-year basis?

Claude Mongeau

Let me put it to you this way, as I said earlier, we've decided not to change our guidance. But we have said that we will achieve a solid end to the year and that we are guiding to approximately 25% that has wiggle room. So, if you do the straight math, you know, it gives the number that you give. But I think our fourth quarter, our third quarter results good and we expect our fourth quarter to be good and if the economy stays with us, we should finish the year on a strong note.

Tim Axtell – Banc of America

Okay. I just wanted to clarify that there was nothing that you are looking in fourth quarter that would cause it to be flat like any unknown expenses or anything that's not what you're saying or indicating right?

Claude Mongeau

No, we said quite the reverse, that we see good bulk movements and continued opportunity to accommodate that business with low incremental costs and finish the year on a strong note.

Tim Axtell – Banc of America

All right, I appreciate that clarification. Keith, can you just talk a bit about the cars or locomotives still in storage so we can kind of get a concept of maybe the incremental market potential still on the docket there?

Keith Creel

Yeah, we still have just under 200 locomotives in storage. And we're still in the process of acquiring orders that we placed with locomotive producers, we've got locomotives coming online fourth quarter of this year and again first quarter of next year. So, there's still a lot of runway left.

Tim Axtell – Banc of America

And cars?

Keith Creel

On the car side? Same thing. Same story effectively for lack of a better term. I mean, we're up in the 100,000 range as far as cars online. We still have fleet on the (inaudible) effectively across the board. There's no fleet really that we have that's constrained right now.

Tim Axtell – Banc of America

Okay. And then just lastly if I can throw in on the export side. Are you seeing the weak dollar driving any exports or can you talk about the currency shift and how that's altered any of your business flows?

Claude Mongeau

Maybe what we see is, if it is a weak US dollar or strong demand from Asia. But out of BC what you're exporting natural resource, bulk natural resource container this is obviously the area of very strong focus for us as well as an area where the potential is real. If you look at lumber industry who has real tough time in the US partly because of the strong Canadian dollars they're finding ways to make it up through a lot of product to China mostly by container.

So some of these things are maybe seeing slowly some permanent shift to where the market for each is going over long run and we'll see it how these things play out.

Tim Axtell – Banc of America

Great. Thanks a lot. I appreciate it guys.

Claude Mongeau

Yeah.

Operator

Thank you. The next question from Gary Chase with Barclays Capital, please go ahead.

Gary Chase – Barclays Capital

Good evening everybody. Two quick questions, wondered if J.J. could maybe comment a little bit on some of the business that either you referenced on the steel side where you're taking some truck competitive business, wondered if you could give us a little flavor for what the yield dynamics were there and to what extent if it was material if it might have impacted your yields in that segment during the quarter.

J.J. Ruest

I think when you look at the yield for M&M probably the impact was iron ore. Iron ore business was way up, iron ore short fall and that impacts RTM, but if you go back to market share, we're getting on steel, that business is profitable.

We didn't do this on price. The reason why people weren't using us in the past was not because of the price it was because of our response time. When you place an order with a trucker, you could get to your plant within two days. The lead time for the trucker to move the product to market is short versus railroad lead time.

So we had to work first and foremost in having our fleet closer proximity to steel mill and to willingness on our side to look at our order system so people can actually try us with shorter lead time order. And that's what we've done and that's what's being paying now.

We've got strategic locations of cars and key pads near Hamilton as well southern Montreal. I believe these to fulfill short lead order because shorter lead time is what's allowing us to compete with trucks.

Gary Chase – Barclays Capital

So if you clean it up on an apples to apples basis, it's safe to say it's as good as or better than?

J.J. Ruest

Yeah, and by the way these don't affect the same store price, because they're new movements they don't go into filter for same store activities.

Gary Chase – Barclays Capital

Okay. And then I was wondered if you guys can maybe broadly comment, you know, maybe for Keith or Luc, but are any of these initiatives creating some cost impact in the near term that we should think might go away or dissipate over time? You know, when you think about some of these initiatives like getting cars closer, you know, to these customers, is there some sort of, you know, spool up cost that we should be thinking about as impacting the results that maybe will dissipate or improve with time or you're seeing most of the benefit already?

Luc Jobin

I would not – I can tell you now that they're quite lively discussions J.J. and I are both on the same sheet of music. He understands, the critical nature of maintaining our operating models so in these locations where we've strategically stored cars, there's not any material cost at all involved.

It's effectively putting the cars on track, it is adjacent to these facilities and when the call comes for that last minute order provide the flexibility we'll stop the train, we'll pick the cars up and we'll set them off in the industry jobs that are currently servicing those locations will spot the cars. In the past we were not that flexible. With this model we have the ability to that There's not a lot of cost built into it. So therefore there wouldn't be any one fall down the line.

J.J. Ruest

If I may add on the terminal agreement that Claude referred earlier, these agreements are two-way agreement there’s things that we want and ask from the terminal operator from southern operations which is valuable to our scheduled railroad model and there’s things that terminal will ask from us. This is really not a gift, it is a trade where we create value for them and they help us create value for themselves on the efficiency side.

Water front was not the most productive front.

Gary Chase – Barclays Capital

Okay guys. Thank you very much.

Operator

Thank you. The next question is from Benoit Poirier with Desjardins Securities. Please go ahead.

Benoit Poirier – Desjardins Securities

Yes. Thank you very much. Tech recently released their production going forward and it seems there's a nice opportunity with you with the restart of Quintette. Could you maybe quantify what could be the potential contribution for you and what is the CapEx implication on this particular opportunity?

Claude Mongeau

We too saw that Tech may decide later this year whether or not they will reopen Quintette. Quintette is located where, you know, the port of choice would be Rupert where there is capacity. I don't believe that we will have much capital investment if any. It's something we did in the past, something we would be happy to do again. And there's capacity at port of Prince Rupert for more so that would be an upside.

Benoit Poirier – Desjardins Securities

Okay. Excellent and maybe my second question is for Keith, you've been talking about the investment on the new locomotives. Could you maybe quantify what we should expect in terms of fuel efficiency going forward in terms of GTMs per US gallon of fuel consumed?

Keith Creel

Well, our guidance and our expectation is to finish the year in 3% area and that’s what we look to go on a forward basis and we do that as we effectively we get better deploying these DP locomotives and also we're implementing some newer technologies as well with cruise control and with systems that allow us to drive cars with horsepower (inaudible) fuel gain. So there are several things in the pipeline that will step through that will allow us to maintain that run rate.

Benoit Poirier – Desjardins Securities

Okay. Thanks for the time.

Claude Mongeau

Okay.

Operator

Thank you. The next is question from Fadi Chamoun with BMO Capital Markets. Please go ahead.

Fadi Chamoun – BMO Capital Markets

Thank you. Good evening. Maybe different kind of question to Claude and Luc. If I'm looking back at 2009. You had very strong financial metrics I'm looking at EBITDA reported very strong free cash-flow in one of the worst years for the industry in a very long time. So I'm thinking with 2009 sort of in the rear – looking back at it wondering whether you feel that maybe you have more room in the capital structure to move more towards that and particularly given the low interest rate environment perhaps increase and create some shareholder value in the process and how would you balance this, I guess, perhaps opportunity to get strong balance sheet for potential M&A in the future?

Luc Jobin

Basically we do have an on-going stock by back – buy back for the year as I mentioned earlier. We have – we're in the process of completing it and so that, you know, that's out there. Going forward obviously we do want to make sure that the business, you know, it's fully supported in terms of reinvestment, then we look to increasing dividend and last but not least share buybacks if there's, you know, excess cash we don't necessarily see our ratios as being out of lack they're a little bit lower than our stated targets. We’re not uncomfortable with where they are now. And we also have to look going forward at the pension situation to make some of these decisions.

So, you know, we'll be reviewing it on an on-going basis and, you know, we want to continue delivering excess shareholder value to the extent we can.

Fadi Chamoun – BMO Capital Markets

Okay. Thank you.

Operator

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

Jeff Kauffman – Sterne, Agee & Leach

Thank you very much. Congratulations on very solid quarter. Luc I just have one question. When I look at the cash flow reconciliation for free cash on Page 16 of your slides, payments for income taxes is a reduction of cash-flow about 186 million. Normally when you're growing the way you are, it's a source of cash-flow through deferred taxes. Is this a timing issue and does this reverse in any point in' 11 and become more of a driver of cash?

Luc Jobin

It's actually going to be the opposite. $186million is the amount that we've actually paid in cash taxes in 2010. Because of the way the Canadian tax structure goes, we are paying lower tax installments in 2010 because it's really on the basis of our 2009 income.

So this will create a headwind as we get into 2011 probably to the tune of some, you know, 250 to $300 million additional cash taxes which will have to be paid. So as far as we stand for this particular year, 2010 we expect to be having cash taxes above 225 million so, you know, there's not – there's not – this is not going to be a tail wind. I think this is going to be a strong headwind as we get into 2011.

Jeff Kauffman – Sterne, Agee & Leach

Now, isn't there some offset because the net income in your cash flow statement will reflect the accrual of taxes at the 27, 28% rate, or no?

Luc Jobin

That’s the accrual which is actually backed out and then you put through the actual cash that you pay, so that's why – that's why, you know, you're seeing 186, but in your 806 you actually have some 200 – $344 million of deferred taxes which are back taxed [ph].

Jeff Kauffman – Sterne, Agee & Leach

Okay. Luc, thank you.

Luc Jobin

Welcome.

Robert Noorigian

Thank you. Well, I think that's the end of the questions and I just would like to thank you again for taking the time in your busy day to listen to our third quarter results. We are pleased with them and we hope that we will have a good fourth quarter results to report in a couple months. Thank you.

Operator

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

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