Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Kansas City Southern (NYSE:KSU)

Q1 2012 Earnings Call

April 24, 2012 08:45 am ET

Executives

Dave Starling – President and Chief Executive Officer

Dave Ebbrecht – Executive Vice President, Operations

Pat Ottensmeyer – Executive Vice President, Sales and Marketing

Mike Upchurch – Executive Vice President and Chief Financial Officer

Analysts

Bill Greene – Morgan Stanley

Chris Wetherby – Citigroup

Tom Wadewitz – JPMorgan Chase & Co.

Matt Troy – Susquehanna Financial

Ken Hoexter – Bank of America

Scott Group – Wolfe Trahan

John Barnes – RBC Capital Markets

Anthony Gallo – Wells Fargo

Brad Delco – Stephens Inc.

Allison Landry – Credit Suisse

Jason Seidl – Dahlman Rose

Tyler Brown – Raymond James

Operator

Greetings and welcome to the Kansas City Southern First Quarter 2012 Earnings Call. A brief question and answer session will follow the formal presentation. (Operator instructions) As a reminder, this conference is being recorded.

This presentation includes statements concerning potential future events involving the company which could materially differ from events that actually occur. The differences could be caused by a number of factors, including those factors identified in the Risk Factors section of the company’s Form 10-K for the year ended December 31, 2011 filed with the SEC.

The company is not obligated to update any forward-looking statements in this presentation to reflect future events or developments. All reconciliations to GAAP can be found on the KCS Web site, www.kcsouthern.com.

It is now my pleasure to introduce your host, David Starling, President and Chief Executive Officer for Kansas City Southern.

Mr. Starling, you may begin.

Dave Starling

Good morning and thank you for joining us on Kansas City Southern’s First Quarter 2012 Earnings Call. Presenting with me today are Dave Ebbrecht, our EVP of Operations; Pat Ottensmeyer, our EVP of Sales and Marketing; and Mike Upchurch, our EVP and Chief Financial Officer.

To start out, obviously we’re very pleased with the results KC has posted. First quarter revenues, carloads and operating income are record. A few things that stand out as important contributors to these results, first, our Cross Border revenues increased 28% in the first quarter over a year ago. A 26% increase in Cross Border grain revenues and an 87% increase in Cross Border Intermodal were key contributors.

What’s also nice about our Cross Border traffic, it represents some of the longest lengths of the haul on the KCS network and that drives not only our revenue, but profitability as well.

Automotive was also strong in the first quarter with revenues up 21%. We view 2012 as kind of a bridge year in our automotive business as we look ahead to the impact of planned expansions and new plants coming online in 2013, ’14 and ’15.

But as it’s turning out, we’re seeing good growth in 2012 due to increased auto production. The latest forecast calls for 2012 North American auto production to be around 14.8 million vehicles, which would be up 13% from 2011. Still below the 16.3 million in 2006, but definitely moving in the right direction.

As we’ve noted in other meetings, auto manufacturing in Mexico is projected to increase by over 40% by 2015 and KCS stands to significantly benefit from the growth. Pat will provide more color on the recent decisions made by Honda, Mazda and Nissan to build or add to their plants in Mexico. We also are being told a major European manufacturer is looking at plant sites in Mexico as well.

Auto production has a ripple effect as new plants provide an opportunity for KCS to move raw material and auto parts into Mexico and then finished vehicles for the local market, US and Canada, as well as exports to Lázaro Cárdenas for the central and South American markets.

It’s also becoming increasingly clear to us that KCS is beginning to experience the tangible benefits of the near sourcing phenomenon taking place in Mexico. We talked about it for the last few years and now it’s really starting to take hold. We’re basically just on the front end of this production migration from Asia to Mexico. The perfect wave of competitive wage rates, favorable currency environment and significantly lower transportation rates to US markets are all in play and we’ll see it rippling through our various business units.

During the first quarter, we continued to strengthen the company’s capital structure and balance sheet. In March, we took advantage of a favorable interest rate environment to enter into a $275 million bank term loan arrangement at a very attractive rate. KCS then used the bank term loan to redeem KCSR’s 8% senior notes. We took out approximately $175 million of the notes in the first quarter and we’ll redeem the remaining $100 million in this quarter.

When we complete this refinancing on a go-forward basis, our annual interest expense will be just over $100 million. In 2009, we paid $173.7 million in annual interest expense. The turnaround has been pretty spectacular.

We will continue to look at other opportunities to reduce or refinance debt. On the horizon are the 12.5% notes at KCSM, which are callable in 2013. We will continue to do what makes the most sense with our free cash to reduce debt and cost and I can assure you we’ll have adequate resource to fund our growth opportunities in whatever form they may take.

Once again, the steady improvement of our financial strength was noted by a rating agency. In March, S&P upgraded its rating of KCS to be B+, only one notch below investment grade. KCS remains fully committed to achieving investment grade status. In addition, as you all know, KCS declared a quarterly cash dividend to its common stockholders. While KCS is still very much a growth company with outstanding short- and long-term business opportunities, our cash profile is such that it made sense to initiate the dividend at this time.

The underlying message we hope this sends out is that KCS is both a dynamic growth company with a one-of-a-kind rail franchise and is also a stable, well-managed and financially strong company.

My final overview observation is in regards to the recent announced labor agreement signed with the Mexican railroad union. Mike Upchurch will provide a little color on the agreement in his remarks. This is a good agreement for all involved. The benefit to KCS is apparent, but it also benefits KCS union employees as it provides a framework for more stable and predictable annual cash payout.

If you go to the next chart, you can see KCS’s first quarter volumes and their revenues came in a bit better than the guidance we gave in 2012 back in January. The growth in volumes and revenues are especially noteworthy given the headwind we faced in our utility coal business.

Our 71.2% operating ratio was also a record for a first quarter for KCS. It marked a 2.6 point improvement from a year ago and was also sequentially improved from the fourth quarter. Despite a higher corporate tax rate resulting from the impact of the strengthening peso on our Mexican tax rate, KCS adjusted diluted EPS came in at $0.75, a 29% improvement over first quarter 2011.

Turning to the next slide, you can see our first quarter compared favorably with our 2012 guidance of mid-single digit volume growth, mid-single digit pricing and low double digit revenue growth.

But knowing the audience I’m speaking to today, I’m sure the primary question is how does the rest of the year look? I say there’s absolutely nothing we see in our business at this time that would lead us to back off of earlier guidance. It looks like our utility coal business will pick up in the second quarter. We have all of our coal plants receiving coal at this time. Just remember, coal was only 14% of our revenue in 2011.

We are beginning to see movement of crude oil to the Bakken region and our participation in the movement of frac sand is expanding rapidly. Pat will provide more color on the entire energy sector.

US economy is definitely stronger than it was a year ago and seems to be slowly gaining momentum. As I mentioned before, near sourcing is beginning to have more of an impact on an already faster growing Mexican economy. The bottom line is that KCS has started the year on a strong note. We’re optimistic that we’ll be able to sustain solid growth throughout this year.

With that, I’ll turn it over to Dave Ebbrecht.

Dave Ebbrecht

Thanks, Dave. Let’s go to slide 9 where I’d like to explain how we plan for and invest in our projected growth. We consistently review and adjust our three- and five-year plans for growth. These plans fall into three operational categories: Infrastructure, Human Resources and Rolling Stock.

For Infrastructure, we’ll continue to invest in our mainline capacity to increase storability, speed and flexibility. Our extensive modeling and bottleneck analysis of our five-year plans allow us to methodically invest in a timely manner.

Our Human Resources are also modeled by each district of growth, at least quarterly. We are relatively flat year over year in terms of overall headcount. We are remaining relatively flat due to attrition as we hire regularly to accommodate our progressive growth. In fact, we were actually just recognized by the First Lady for the significant amount of veterans we have hired as part of her Joining Forces initiative.

And lastly, we have plans to invest in our Rolling Stock. I am pleased to announce that we have entered into a locomotive multi-year purchase agreement. We will acquire 30 locomotives by the end of this year and receive 20 each year through 2015 with options to surge upward with growth in any one year. We’re also investing in Automax and intermodal cars to ensure we have adequate supply to accommodate growth in Mexico.

Turning to slide 10, I would like to reemphasize our consistent ability to control cost. As you can see, Ops cost, which is the bottom red line on the chart, has remained largely flat over the past three years as we have experienced a significant increase in Linehaul revenue. Our judicious expense management and cost control in these areas have been a major driver of our OR improvement over this timeframe.

On slide 11, you can see our headcount is still very solid. The only reason we show a dip in this efficiency metric is due to 13,000 less carloads shipped from the fourth quarter to the first quarter, but this is a normal seasonal pattern and we still expect our efficiency to trend upward throughout the year.

On slide 12, you can see our operating metrics continue to remain in a very good range for the first quarter. Velocity is solid, averaging above 27.5 miles per hour. We also continue to improve our mainline infrastructure to sustain the validity of the network. Dwell, Slow Order Miles and Car Efficiency were slightly impacted by the major curfew activity we had on the Laredo sub.

As a recap of the first quarter on slide 13, I just want to reemphasize that we continue to exercise good cost control while absorbing record volumes and remaining very fluid. We continue to be very diligent in maximizing production and creating efficiency in all major cost areas.

PTC is on track with our published implementation plan and we were recently notified that we have won our sixth straight Harriman Gold Award for safety, which we will receive next month.

Now, I’ll turn it over to Pat for Sales and Marketing.

Pat Ottensmeyer

Thanks, Dave, and good morning, everyone. I’m going to begin my comments on slide 15 with a quick recap of revenues and volumes for the quarter. As you saw earlier in Dave’s introduction, our revenues for the first quarter were $547.5 million, up 12% from last year, driven primarily by a 7% increase in carloads. Both revenue and carloads were the highest for any first quarter with revenues also setting a new record for any quarter.

Revenue per unit was up 5% and also set a new record. Four of our six business units had higher RPU during the quarter, which, as you will see later, was driven largely by record Cross Border revenue.

The next graph illustrates the factors contributing to year-over-year revenue growth and you can see that every component was positive except for foreign exchange. Core pricing contributed $14 million of the revenue increase over last year and the increase is in the mid-single digit range that we have experienced in previous quarters and the pricing environment continues to be strong and positive and our outlook is unchanged from the mid-single digit guidance that Dave gave earlier given in previous quarters.

The increase in fuel surcharge revenue contributed $18 million, or 30% of the total revenue growth. Mike Upchurch is going to talk more about fuel in a few minutes. Foreign exchange continued to have a negative impact on revenue growth as the peso was about 7% higher than in the previous year. Mix and other was higher than last year due primarily to increased length of haul, which was a function of higher Cross Border revenues and mix within the major business units was also a positive contributor.

Turning to the next slide, 17, beginning this quarter we have reconfigured and expanded our coal business unit to better reflect the company’s diversified opportunities in the broader energy sector. The coal business unit has been renamed Energy and now contains movements of crude oil, frac sand, export coal and other alternative sources in addition to the unit coal and petroleum coke that has been included in the past.

As is the case with all the other railroads, our coal volumes and revenue dropped fairly sharply in the first quarter due to factors that are well-known, such as unusually warm winter weather and low natural gas prices. However, as you can see from this chart, we experienced significant growth in the other commodity groups, primarily frac sand, which substantially offset the decline in utility coal.

You’ll when we publish the more detailed reports, the frac sand year over year volume was up 25%, revenues were up 70%, length of haul was up 80% as we were getting more longer haul frac sands, primarily from the Great Lakes region down into south Texas.

Longer term, we believe that low natural gas prices driven by the new oil and gas discoveries in North America will be positive for KCS, even though this will be a negative factor for our utility coal business. In other words, the potential negative impact to coal will be more than offset by strength and growth in frac sand, type and crude oil shipments.

In addition, low natural gas prices have driven several recent announcements for new ethane-based production capacity, which will help our chemicals and plastics business unit in the long run as much of this new capacity will be located in KCS service territory in the Gulf Coast. I’m going to talk more about that in a few minutes, as well. By the way, we will be restating our 2011 results for the new Energy business unit in the investor package that will be on our Web site later today.

Turning to slide 18, you can see the individual business unit performance in more detail. Again, the record revenue was driven by strong performance in all business units except Energy and record revenue per unit in four of the six businesses. As you saw earlier, the peso was weaker than last year and cost us about 1% revenue growth versus last year. In other words, our revenue growth would have been 13% higher than last year had the peso just been flat during the quarter.

Other than Energy, our Chemical and Petroleum business was the only area of weakness compared to last year as volumes were 2% lower than the first quarter of 2011. The major contributor to this decline was the loss of a petroleum move due to a dispute between one of our customers and one of their shippers. If we were to remove this customer from the comps, volumes in this business unit would have been 3% higher than last year.

Ag or Chemical shipments were lower due to a one-time move that occurred in 2011. The rest of this business is performing well and we believe the petroleum move I just mentioned could return sometime later this year so we could have some strength or upside in the beginning of the second quarter.

Strength in metals and paper drove the performance in our Industrial and Consumer business. The Metals business was particularly strong with volumes up almost 15% and revenues about 28% higher than last year. This was somewhat offset by lower appliance and military shipments. Cross Border revenue in this unit was at a record level with a 27% year over increase, which was obviously a factor in driving the revenue per unit up by 13%.

Agricultural Minerals also saw strong RPU and revenue growth versus last year. Revenue growth reflects weaker comps last year in the first quarter as the result of some shifting in sourcing patterns primarily to local Mexican sourcing in Bethel that had occurred in 2011. So last year we were moving about the same number of carloads within Mexico, either from Mexican origins or ports that we are now moving over Laredo. This is the primary driver of the increase in RPU.

Cross Border revenue increased by 26%, which drove Cross Border traffic to an all-time high 53% of total revenue in this business, which, by the way, is the highest of any of our business units. I talked a lot about the Energy business unit earlier so I won’t spend any time here and I’m sure there will be questions later.

The Intermodal business continued its superior growth profile and achieved record-breaking revenue per unit in the first quarter driven by very strong performance in Cross Border growth. More detail on that in a moment, but all aspects of our Intermodal business were strong during the quarter and we see tremendous strength in our new business pipeline going forward.

Automotive revenues were higher than any prior quarter, breaking the previous record set in the fourth quarter of 2011. This was driven by multiple factors including increase in volume, strong core pricing, a doubling of our cross border shipments. As Dave mentioned earlier, North American auto sales were very strong in the first quarter and our business was further strengthened by market share gains and increased movements through Lázaro Cárdenas.

The next slide shows our Cross Border revenue, which, as Dave mentioned, increased by 20% over last year, more than double the rate of our overall revenue growth. The increase was pretty broad-based with three business units setting all-time records for Cross Border revenues.

Intermodal and Automotive were the fastest growers, but Ag and Minerals is the largest in absolute terms and, as I mentioned, was 53% of that business unit revenues. This chart is not only evidence of the growth in trade between the US and Mexico, a strong validation of value of our Cross Border franchise. That said, we could see some declines in the second quarter and third quarter as a result of normal seasonal factors, particularly in the grain business.

The next slide, 20, gives you a better picture of the Cross Border volume and revenue growth specific to the Intermodal business. As you can see, we experienced -- continue to experience rapid growth in the Intermodal Cross Border with 78% increase in volumes and 87% increase in revenues.

In the past, we have said that the Cross Border Intermodal business was growing rapidly, but from a small base. The base is obviously getting larger. Since we opened the Victoria-Rosenberg line in the third quarter of 2009, Cross Border volumes and revenues are both up by approximately 300%. Most remarkable is that the growth rates are continuing in the high double-digit range and the pipeline continues to be very strong. Again, we feel this is clear validation for the investment we have made in our Cross Border Intermodal network and the value of our franchise.

Moving to slide 21, during the quarter we had solid growth continued in the International Intermodal business at Lázaro Cárdenas with 28% increase in volumes and 26% increase in revenue over last year.

What makes this performance even more remarkable is at the end of last year, we lost one of our top four carriers completely, which represented more than 10% of our Lázaro volume and revenues during 2011. As information due to changing business conditions, that carrier chose to consolidate their business, exit certain markets and reduce the number of ports of call.

Clearly, much of the business stayed at Lázaro as our first quarter volumes with all other carriers grew by 45% over last year, so the loss of this carrier was clearly absorbed by the remainders. We remain very bullish on the outlook for growth at Lázaro Cárdenas as capacity grows in the years ahead as it is the most efficient way to serve Mexico City and the surrounding areas.

Moving on to the market outlook slide, you can see that we are very positive about the outlook for the second quarter and the remainder of 2012. As Dave mentioned earlier, in spite of obvious concerns about coal, we are still comfortable with our low double-digit guidance for revenue growth.

I will reiterate what I said in the fourth quarter call that foreign exchange could make the difference in one or two of these businesses being double-digit versus single. If the peso were to weaken from current levels, it could have a negative impact on revenues in a couple of businesses.

Before I get into business unit details on this slide, I’d like to make a general comment or two about our volume so far in the month of April. The first thing I would say is that the timing of Easter, which occurred early this year and very late last year, was a definite headwind when looking at our early 2012 year-over-year results.

We have now made up those negative early comps, and through April 22nd, our total volumes were essentially flat to last year. If we exclude the decline in utility coal, our volumes were actually about 4.7% higher than 2011 through April 22nd.

Most importantly, we are simply not hearing any talk about a softening or decline in business level from any of our major customers. In fact, for the week ending last Thursday, April 18th, which is more recent than the publicly available AAR data, that was the highest volume we have experienced in the last six weeks.

Now, just to touch on a few business unit specifics, Chemical and Petroleum should be flat to slightly positive in the quarter and positive for the full year. As I mentioned earlier, we could see some upside in the petroleum traffic as a result of recovering business lost due to the commercial dispute I described earlier. Industrial and Consumer will continue to benefit from strong metals and paper shipments. The Ag and Mineral outlook reflects normal seasonal trends and tougher year-over-year comps as we move through the year. I’ll talk a little bit about long-term outlook for Cross Border Grain in a couple minutes.

Our Energy outlook may surprise some of you. We’re showing double-digit revenue increase for the second quarter and single digit for the full year. Clearly, some of this is a function of the new configuration of the business unit, the addition of frac sand and crude oil, but most of this improvement in the second quarter is a function of increasing shipments by some of our utility customers who were particularly slow during the first quarter.

As we move into the back half of the year, our visibility into this business gets very murky. Based on the best information we have at this moment, we still believe volumes and revenues will be higher than last year, but predicting what will happen in this business unit has definetly been a challenge this year.

Moving to slide 23, before I go to the wrap-up slide, I just want to touch briefly on our customer satisfaction ratings. You may recall that we first introduced this in the second quarter call of last year and talked about how we were going to make this survey an ongoing process and make sure we were listening to and responding to our customers.

I believe if we’re going to achieve our potential as the fastest growing railroad in the industry, it’s critical that we instill a customer-oriented culture and seek continuous improvement in terms of the experience our customers have with KCS.

Over the past year, we conducted three customer surveys in which we reached out to our top 200 customers in the US and Mexico. We polled at least two different individuals at different levels at each company for a total of almost 450 individual contacts. We received responses from 62% of the companies and 41% of the individuals.

The results are shown on this slide and there are three important points about these results. They are generally very positive with satisfaction ratings in the 90% to 90% overall over the course of the three surveys in the one-year period. The trends are generally improving and the winter survey had the best ratings of the three.

And finally, we’re going to make this, as I said earlier, going to make this a process and has heightened focus on customer satisfaction important -- an important part of our culture and make sure that the overall customer experience does not become an impediment to our growth.

Finally, I’ll make some comments about market developments and longer term outlook for the business. First, we are expecting a positive economic environment to continue in both the US and Mexico for the rest of 2012. Second, we see no fundamental change in our pricing outlook and are comfortable continuing our guidance in the mid-single digit range. I already talked about the Cross Border growth outlook for Intermodal.

I’ll briefly touch on Automotive. Dave mentioned there are three major auto plants and now a fourth, and I think we can say that that’s Audi recently announced that they will be locating a plant in Mexico. The specific location is yet to be determined, but they’ve identified three different sites that they are studying.

This is the fourth global manufacturer to choose Mexico as a site for new production, and again, we believe decisions like this validate what we have been saying for several quarters about the attractiveness of Mexico as well as the substantial growth potential of our Cross Border network.

Our long-term new business pipeline continues to grow. I touched on each of these opportunities in the past, but let me give you an update on two in particular. The Port Arthur crude oil opportunity is becoming a reality and we are moving crude oil to Port Arthur today. This is both in manifest or boxcar service as well as some unit train movements.

Due primarily to questions and uncertainty caused by the recent pipeline announcements late last year and early this year, we have not been able to secure a long-term take or pay type of commitment that we and our partner, Savage, are seeking to construct the Port Arthur crude terminal that we have discussed in the last few quarters.

We still feel that, ultimately, construction of that facility will occur, but right now we are happy moving crude oil in any manner possible and establishing KCS and Port Arthur as a key participant in this market.

We feel that the demand is there and that we can handle sizable volumes, either directly to refineries or at existing KCS facilities. In addition, we are still working with potential shippers interested in exporting US coal through Mexico to Asia and I still believe that this market makes sense if the global demand for coal reaches anywhere near the level most experts are forecasting.

Finally, and the last point on this slide, we believe that there will be a longer term positive impact created by the new large oil and gas discoveries in North America and sustainable low natural gas prices. This will drive growth in ethane-based production in products like polyethylene. In fact, over the last year, companies including M&G Polymers, Chevron Phillips, Formosa Plastics, and most recently, Dow Chemical, have announced plans to build substantial new production capacity in the Gulf region.

While it’s too soon to know what these announcements and these facilities will mean in terms of volume, revenues and timing, we feel that it will be an important growth opportunity for KCS given our position in the Gulf Region and our connections to Mexico.

With that, I will turn it over to Mike Upchurch.

Mike Upchurch

Thanks, Pat, and good morning, everyone. It’s always nice to share record financial results with you and let me begin my comments on page 26.

Revenues increased 12% while expenses increased only 8% resulting in a 23% improvement in our operating income, and you’ll note we had particularly strong incremental margins of right around 50%.

Equity in earnings increased to $5.8 million during the quarter and that’s largely the result of higher profits from PCRC, and Dave will talk a little bit more about that later. Interest expense declined nearly 20% to $27.2 million and is largely the result of lower interest rates from our refinancing activities.

Our average effective interest rate is now 6.5%, and from our peak quarterly interest expense level, we have reduced interest by $73 million annually and with some of our refinancing that we’ve just completed, we expect that number to increase to roughly $80 million by the end of the year.

Due to the strengthening of the Mexican peso, we did benefit from a $3.9 million foreign exchange gain during the quarter and as information, the peso improved from 14 at the end of the year, end of 2011, to 12.8 at the end of March this year.

Debt retirement costs and other were $12.8 million during the quarter, largely relating to the refinancing of the 8% notes and I’ll cover that in more detail in a few slides. Income tax expense did increase 46% due largely to higher pretax income and an increase in the effective rate due to foreign currency strengthening.

Our effective tax rate was 41% during the first quarter, which is consistent with the low 40 guidance that we provided in January on our 2011 year end call and reaffirmed during several investor conferences during the quarter. For the full year, we continue to project a tax rate in the low 40% range and that’s based on an assumption that the exchange rate will stay at 12.8, which is the official forecast from the Central Bank of Mexico, and I’ll provide a few more comments on our tax rate in a few slides.

Finally, adjusted diluted earnings per share increased 29% to $0.75. I do think it’s important to note that our EPS net of the foreign exchange impact in both our income tax line item and the foreign currency line item was negatively impacted by approximately $0.03 during the quarter.

Moving to slide 27, let me cover operating expenses. Operating expenses for the quarter grew 8% over 2011 levels. Volume-sensitive costs such as car hire, fuel usage, intermodal lifts and variable labor did contribute approximately $17 million to the year over year increase. Fuel price, which I’ll discuss in a couple of slides, contributed about $10 million to our increase. Our estimates around inflation are that they added about $9 million in costs in the quarter and are always a bit difficult to pinpoint, but we believe that our rail inflation is up about 2% to 2.5%.

And then finally, expenses benefitted by $7 million from the strengthening peso, and again, just to remind everybody, we have a bit of a natural hedge there in our P&L, so from an operating income perspective, we really didn’t see much of an impact during the quarter.

Turning to page 28, Comp and Benefits expense did increase 9% to $109 million, primarily wage inflation and volume-sensitive costs contributed about $5 million while the remainder was due to increased incentives, offset by some FX benefits due to the changing peso rate, and as you can see, our headcount was essentially flat year over year allowing us to deliver strong, very strong operational improvements that Dave Ebbrecht spoke to earlier.

On slide 29, Dave mentioned in his opening comments the negotiation with the Mexican labor union. We announced that last week in an 8-K and what we have essentially done here is to provide our employees in Mexico more certainty around our annual cash profit sharing while providing KCS savings in a more consistent profit sharing expense going forward.

So let me review some of the details with you, and most importantly, how we expect our GAAP financials to be impacted. As background, Mexican law does provide all employees the right to participate in a profit sharing plan based on a statutory income calculation. And while we’re creating a services company and shifting the employees to the new company, all of our employees will still participate in the profit sharing plan.

Our agreement with the union will continue to pay all of our employees cash-based payments that will be stable and more predictable going forward. In fact, the 2012 anticipated payment is expected to be approximately 37% higher for our union employees than the cash payment for 2011.

And for management employees, our current annual incentive plan actually exceeds the calculations under the statutory profit sharing plan. So our agreement removes some of the annual volatility of the PTU payment that, in background, has ranged anywhere from 4,000 pesos to 16,000 pesos over the past few years and can be subject to significant fluctuations due to business conditions, foreign currency swings, depreciation, amortization of the concession, and debt retirement costs, as examples.

So these factors can cause significant swings in cash profit sharing payments and are the primary reason behind our deferred liability, which is very similar to how we account for timing differences related to income taxes, which I’m sure most of you are familiar with. In return, this agreement provides KCS a much more stable and consistent PTU expense in the future.

So let me cover with you how we’re going to record this in the second quarter. As a result of the agreement, we anticipate in the second quarter recording a one-time non-cash benefit of approximately $40 million that represents the cumulative deferred liability that we had on our books at the end of 2011.

Additionally, we will reverse approximately $7 million of first quarter deferred PTU expense, first quarter of 2012, and lastly, as the result of this specific transaction, we estimate that the 2012 compensation and benefits expense reduction will be approximately 4% of our full year 2011 comp and benefits expense.

Moving to page 30, fuel expense was up 10%, and as I mentioned earlier, largely driven by price increases. In the bar chart, you can see our average price per gallon was $2.84 during the quarter, and you’ll be pleased that beginning this quarter we included more information around fuel prices and gallons consumed in our investor report, which is available on our Web site under the Investor Relations section. Volume contributed to a $4 million increase in fuel expense while foreign exchange and fuel efficiency contributed a $6 million reduction in fuel.

On slide 31, equipment costs declined $3 million despite higher volumes. The primary contributor to the decline in equipment costs was the locomotive lease buyout that we completed last September, and as you can see, it contributed about a $4 million reduction to equipment costs, and coupled with higher depreciation in the ownership of those assets, contributes about 50 basis points improvement in our operating ratio.

On slide 32, you can see the reconciliation of our statutory tax rate of 35% to the effective rate for first quarter 2012 of 40.9%, and also for comparative purposes, we’ve provided the first quarter 2011 rate of 27.1%. In a particular note, you can see the negative impact during the quarter that foreign exchange had, which increased our effective rate by 6.3 points, and the positive impact on our effective rate of 5.7 in 2011.

And as we discussed in prior quarters, these largely offsetting increases and decreases to our effective tax rate in 2012 and 2011 are caused by the tax rules in Mexico related to our US dollar denominated debt that we have at the KCSM level. The peso strengthened from 12/31/2011 when it was 14 to 12.8 at March 31st, and based on the tax laws, this strengthened peso creates an unrealized non-cash income tax expense, since it theoretically requires fewer pesos to extinguish that US dollar denominated debt.

And as a bit of additional color to help you estimate the impact of foreign exchange fluctuations going forward, a 0.1% change in the effects rate can impact our effective tax rate by approximately 50 basis points, so if you follow that in the light of the 1.2 point improvement in the peso during the first quarter, you would have expected a roughly 6 point increase in the effective tax rate for the first quarter, which is consistent with what we’ve illustrated in the top chart where you see the effective tax rate going up by 6.3%.

Finally, turning to slide 33, during the quarter, we delivered strong free cash flows of $38 million, and I’d like to spend just a few minutes reviewing with you our current thinking around the use of cash and briefly comment on our previously announced cash dividend.

As you know, one of our key priorities of the last few years has been to pay off debt. We have reduced our debt by about $430 million and our interest expense by $73 million from peak levels in 2009, and while we believe most of our de-leveraging is behind this, we may opportunistically look at refinancing or potentially retiring with cash the 12.5% notes at the KCSM level, which are callable April 1st of 2013.

And as we reported in the first quarter, we issued a tender offer for our $275 million 8% notes. That was back in February, and refinanced $175 million of that with a new bank term facility, which is priced at Libor plus 125, so providing a significant interest savings. The remainder of those notes, which represent about $100 million outstanding, will be called effective June 1st and we will also plan on refinancing that with a new term loan. This transaction should save us on a full year basis approximately $16 million in pre-tax interest expense.

And finally, as Dave mentioned earlier, we received an upgrade to double B+ from S&P. I think most importantly, they maintained a positive outlook implying we are likely to receive another consideration of an upgrade, and that would be to investment grade, sometime over the next year or so. And frankly, our consolidated credit metrics, as you can see, are to achieve each major rating agency’s investment grade profile.

Moving to investing in the business, as a strong growth company, we will continue to invest and ensure a superior growth profile. As we communicated earlier in the year, our capex to revenue guidance is in the 17% to 18% range, but we do continuously evaluate our growth prospects, and based on a very positive outlook, we plan to take advantage of the 50% bonus depreciation rules that are in effect through the end of 2012, and because of that, have accelerated the purchase of 30 locomotives from early 2013 into late 2012, so our growth opportunities are certainly not lacking in any way.

And finally, as you know, we announced our first quarterly cash dividend on March 30th, our annualized payout of approximately $86 million represents a dividend yield slightly higher than 1%, and we believe our free cash flow and cash balances will be sufficient to continue to achieve our objectives outlined on this page. And while we’re not providing any specific guidance on the dividend, we will continue to thoughtfully consider payouts as our business conditions continue to improve.

And with that, I’d like to turn the call back to Dave.

Dave Starling

Okay, thank you, Mike. If you’ll go to the next slide, 35, as you can see, the Panama Canal Railway continues to do quite well with volumes and revenues up 30% from a year ago. Operating ratios, I have to remind Dave Ebbrecht, came in at 46.1.

Before moving away from the PCRC, Bill tells me that he still gets a lot of questions about the expansion of the canal and the effect on our franchise. First of all, will the widening of the canal hurt the Panama Canal Railway? The success of the PCRC has never been related to the capacity of the canal. The PCRC works on a cost avoidance model that allows an ocean carrier to look at the four ports in Panama as one, meaning you can call one port, move your cargo to any other port by rail to connect with feeders or other services.

It’s the only place in the world that I’m aware of where you can perform a dual ocean train shipment. You can unload from one vessel on one ocean and transfer it to another vessel on another ocean by rail.

The second question we get is whether the widening of the canal may slow down the development of the port of Lázaro Cárdenas. Again, the answer is no. We don’t see any impact occurring at all. Lázaro is destined to become hands down the primary port for serving the core Mexican population centers for goods coming out of Asia. The Panama Canal is really not a factor in serving this population from Asia.

Moreover, as we begin to experience longer hauls out of Lázaro moving into the US, we see the markets being served are not for markets most likely to be served by ships going through the canal. US target areas for traffic out of Lázaro will be Texas and the Midwest and some Southeast regions. Panama Canal traffic is most likely headed to a couple of east coast ports. We’ve always supported the expansion of the canal and continued to believe it would be positive for PCRC and not a negative for Lázaro Cárdenas.

A couple of closing remarks, Pat already alluded to most of this, but if you look at our reported numbers for the first two weeks, you might be concerned that volumes have softened. We are not concerned. We have polled our customers. We’ve spent a lot of time with them. As early as Monday, we’re being told that their orders are still strong. They do not see a slowdown.

Some are saying the mild winter had some effect on customer demand being stronger than usual in the first quarter. Maintenance at some facilities actually started earlier. It started in April rather than May, and the effect of the Easter holiday, which occurred earlier this year, has had a negative impact on our month-to-date comparisons. But we believe the second quarter will have a strong finish and we are very confident in our guidance for the remainder of 2012.

With that, we’ll open it up for questions.

Question-and-Answer Session

Operator

Thank you. We will now be conducting the question and answer session. (Operator instructions) Our first question is from Allison Landry of Credit Suisse. Please state your question.

Allison Landry – Credit Suisse

Good morning. Thanks. So, I was hoping to dig into the crude and frac sand opportunity. Are you guys still moving these volumes on a spot basis or has there been any interest by customers in signing longer term contracts?

Dave Starling

Allison, right now it’s moving -- crude oil, certainly, is moving on a spot basis, mostly, as I mentioned in my comments. That’s the reason we haven’t gone further in terms of the Port Arthur crude terminal that we have been talking about.

Good news, it’s moving and we think it’s going to continue to move, and our hope is that if we get some of these customers comfortable with the rail service and the rail product, that we will be able to sort of migrate some of this spot business into longer term commitments, but right now, it seems like everyone’s just waiting for even more clarity and more certainty on what this pipeline capacity is going to mean.

Allison Landry – Credit Suisse

Okay, and then just as a quick follow up to that, if it did move more to a contractual basis, how do we think about the yields relative to what you’re seeing now? Presumably, it should be a little bit lower if you’re getting a volume commitment? Am I thinking about that correctly?

Dave Starling

Oh, I don’t think so. I think the yields will be good and perhaps -- I wouldn’t expect that there would be any change in the yields or the contributions. Long-term commitments are going to require different capacity and capital considerations, so right now we’re trying to handle this in existing manifest service, largely, so no train starts, no crew starts, no locomotive requirements and minimal capital on the receiving end. If we started to move large volumes of unit trains, we would have some capital considerations.

Allison Landry – Credit Suisse

Okay, that’s very helpful. Thank you for the time.

Operator

Our next question is from Scott Group of Wolfe Trahan. Please proceed with your question.

Scott Group – Wolfe Trahan

Hi, thanks. Good morning, guys.

Dave Starling

Good morning, Scott.

Scott Group – Wolfe Trahan

Pat, why don’t you just clarify some of your comments on coal and the visibility to that improving, at least in the second quarter? Are you talking about improving relative to the down 11% in the first quarter for utility coal, or is that down 40% kind of range we’ve been at the past few weeks?

Pat Ottensmeyer

I’m talking about improvement from the first quarter and improvement from the second quarter of last year.

Scott Group – Wolfe Trahan

Okay, so you think that utility coal will be positive year over year in second quarter?

Pat Ottensmeyer

Yes. Keep in mind, as Dave mentioned, our coal business isn’t as complicated, I’ll say, as some of the other carriers. We have eight plants. We probably have better visibility than some of the other carriers because we only have a handful of customers that we need to talk to, but even that --even with that, the visibility is poor because our customers, one of our major customers, one of our top two coal customers, has now given us five forecasts for 2012.

Scott Group – Wolfe Trahan

That makes a lot of sense. Can you just maybe give us just a little bit of color, then, as what happened over the past month or so when they dropped off some material and then what’s coming back?

Pat Ottensmeyer

Well, what happened is the maintenance and some warm winter weather, and what’s causing it to come back is the maintenance cycles are finished and people are restocking in anticipation of hot summer weather, and I think that’s the visibility and the clarity that we have for the second quarter. Beyond that, it gets really murky.

Scott Group – Wolfe Trahan

Got you. Okay, that’s helpful. And then, Mike, if you can give us a little bit maybe more color on the new labor deal because it looks like it’s about $17 million of annual savings going forward, and just wondering, are there any offsets to that? I guess I’m not sure I understand why the labor wants this.

And then does this impact in any way some of the volatility going forward in terms of either the FX gain or loss, the tax rate going forward of the ability to flex up or down the headcount in Mexico?

Mike Upchurch

Yes, Scott, I think you’ve done the math right on our expected favorable impact to expenses in 2012, but this really has nothing to do with income taxes or FX or headcount levels. This is simply an agreement to try to provide a more consistent cash component to this profit sharing plan and to allow KCS to benefit from a more predictable expense level going forward.

Scott Group – Wolfe Trahan

Right. I mean, so then I guess what I don’t understand is are they getting paid $17 million less than they would have gotten paid? I’m just not sure why -- what’s in it for them to agree to this, because, I mean, it sounds great for you, but I’m just trying to understand if there’s any offset here.

Mike Upchurch

Scott, remember there’s a cash component and a deferred component to this, very similar to income taxes, and what we’ve agreed to do is pay a higher cash component.

I think in the slide we indicated, just for illustrative purposes, that 37% higher than the 2011 payment, but this payment fluctuates pretty significantly and I think we gave you a little bit of guidance on that that it ranged anywhere from 4,000 pesos to 16,000 pesos a year in the last few years, and is just very volatile based on business conditions and a variety of other factors, so this just provides them a little bit more certainty.

Scott Group – Wolfe Trahan

Okay, so this is a EPS benefit for you guys and maybe a little bit of a cash headwind.

Mike Upchurch

Correct.

Scott Group – Wolfe Trahan

Got you. Okay, that makes a lot of sense. Thanks a lot. I appreciate the time.

Operator

Our next question is from Tom Wadewitz from JP Morgan. Please state your question.

Tom Wadewitz – JPMorgan Chase & Co.

Good morning.

Dave Starling

Good morning, Tom.

Tom Wadewitz – JPMorgan Chase & Co.

A follow up on that last question, Mike, how would you model per-worker costs, bearing in mind that you’ve got this benefit in terms of the new agreement in Mexico, and just to confirm, is that -- I guess the $17 million is both a cash savings for you and a P&L savings? Or is it only a cash savings?

Mike Upchurch

It’s a P&L savings, Tom.

Tom Wadewitz – JPMorgan Chase & Co.

It’s P&L. Okay, so how would you model a per-worker looking forward when this agreement is in effect?

Mike Upchurch

Well, we haven’t provided any kind of guidance on a per-worker basis. I think you could do some math on this given the headcount levels that we discussed that would probably get you somewhere in the neighborhood of a $3 million cash payment each year.

Tom Wadewitz – JPMorgan Chase & Co.

Okay, so just -- you could spread the $17 million out over the next three quarters and figure out per worker and that’s a straightforward way that this should flow through?

Mike Upchurch

From a P&L perspective.

Tom Wadewitz – JPMorgan Chase & Co.

Right. Right, okay, good. Good, thanks for that. In terms of the coal comments, it sounds like you’re surprisingly constructive on second quarter for coal, which is, I guess, a nice change from what we’ve heard from some others.

The eight plants that you serve, would you view those plants, and I understand you have limited visibility, but do you think the customers are viewing those plants as being base load or is the utilization that you’re talking about at all eight of those plants essentially a seasonal pattern, where you have a hot summer in Texas and you just don’t have capacity to have those offline?

Or how do you think it would be reasonable to look at those plants on a kind of a broader basis looking forward and in terms of how they’re utilized?

Mike Upchurch

By the way, I will correct something. I made a mistake. We actually serve nine plants, not eight. I forgot about one that we just took on this year.

Generally, they have been base load. They have been considered base load plants, but obviously, when you combine a very warm winter, and in particular in Texas where you have a deregulated environment and natural gas, competition from natural gas fired plants with demand being down because of the weather, even base load plants are going to be affected.

But I would say we have always considered our utility plant customers to be base load demand or production.

Tom Wadewitz – JPMorgan Chase & Co.

Okay, and you think that’s still true looking forward?

Mike Upchurch

Yes.

Tom Wadewitz – JPMorgan Chase & Co.

Okay, great. Thanks for the time. I appreciate it.

Operator

Thank you. Our next question is from Chris Wetherby of Citigroup. Please proceed with your question.

Chris Wetherby – Citigroup

Great, thanks. Good morning, guys.

Dave Starling

Good morning.

Chris Wetherby – Citigroup

Pat, maybe a little bit of detail on the pricing comments. Just wanted to clarify it. I think you mentioned that it was roughly in line. Just looking at your bar chart and the slides, it seemed like it was a little bit lower. I just want to get a sense of how maybe mix or FX impacted that and just get maybe a little bit more clarity on how pricing factors in the quarter.

Pat Ottensmeyer

It was very consistent with prior quarters, Chris, and then we try to strip out, to the extent possible, from price, things like mix and FX. But as we have come to better understand over the course of the last few years and quarters, there are a lot of moving parts, so we don’t see -- our pricing, if you look at our peer pricing, our core pricing, very comparable to what we have shown over the last several quarters.

And more importantly, we don’t see any change that would cause us to change our outlook in the guidance to mid-single digits is where we believe pricing is going to stay.

Chris Wetherby – Citigroup

Okay, so the $14 million from the slide maybe includes some mix? Or is that the straight number? That seemed like, just based on a year-over-year number, that that was in the kind of upper twos or lower threes or so.

Pat Ottensmeyer

No, it’s higher than that. You’ve got to understand that not all of that core pricing only relates to a roughly 60% to two-thirds of our total business. Again, when we look at same store-type pricing, core pricing, we measure that off of similar moves and that’s generally been in the ballpark of two-thirds of our total revenue.

Chris Wetherby – Citigroup

Okay, that’s very helpful. And then just one other comment you made on the Cross Border seasonality, just want to get a sense of what you’re thinking about for 2Q and beyond.

I think you mentioned that there was a potential for some seasonal effects, particularly on the grain side, but you want to get a sense of that, and then reminding from last year, I feel like you had some disruptions, particularly on the grain network as you moved into the summer from flooding. Just want to get a sense of how that factors into Cross Border.

Pat Ottensmeyer

Generally speaking, the first and the fourth quarter of any year are the strongest for grain, and that’s particularly true for Cross Border because what you’ll have is competition from the local harvest.

Mexico has been in a pretty serious drought condition for the last year, so a lot of the country has been affected, and, with the exception of the northeast, the Tamaulipas area around Matamoros, they have not had the drought conditions and they’re looking at a pretty good harvest.

That’s a big, mostly milo and some corn production, so what we would expect is that when that harvest comes in, when that crop comes in, that will affect some of our Cross Border movements as our customers would be looking to source locally, and that’s the main driver to the seasonal comment that I made.

Chris Wetherby – Citigroup

Okay, so kind of isolated to the grain side, not intermodal or auto? That should continue to persist normally?

Pat Ottensmeyer

No, I would not expect any seasonal -- I mean, you’re going to have some seasonal patterns in the Intermodal business similar to what you have in the US, but that should not be a drag on our Cross Border growth or Intermodal.

Chris Wetherby – Citigroup

Okay, great. Thanks for the time, guys. I appreciate it.

Pat Ottensmeyer

Thank you.

Operator

Our next question is from the line of Bill Greene of Morgan Stanley. Please proceed with your question.

Bill Greene – Morgan Stanley

Hi, there. Good morning. A question for some clarification on the guidance that you gave, so you basically kept it where it was. You had bit of a beat relative to that, so can any of this beat roll forward?

Should we think of their -- as the potential for having upside to guidance, or are there some of these offsets we need to consider? Your comments on the economy seemed pretty upbeat, so I’m just trying to think about how I should roll that in.

Mike Upchurch

Bill, this is Mike Upchurch. Yes, I think you’re right. We’re probably a little bit ahead at the first quarter here. Certainly, it’s always difficult to anticipate everything that’s going to happen the rest of the year here, but we feel pretty good based on the rest of the year, the insight that we have from our customers, and certainly, when you look at our OR going forward, we would expect to see some continued improvement there.

Bill Greene – Morgan Stanley

Do you feel like weather had a very big effect at all?

Dave Starling

This is Dave Starling. Not really on our network. We’re not as far north as some of the other carriers. Usually when we get affected by the weather, it’s more from our connecting line carriers that the car interchange slows down and the systems get a little sluggish, but it’s certainly played a positive role, but it’s not significant enough to move the needle.

Just to -- kind of a follow up on what Mike Upchurch said, we had strong auto sales in the first quarter. I think the good weather got a lot of people out making purchases. I know I bought a new car and had to wait in line to process it because they sold five within an hour, so I think you’re seeing this played out now in the volumes that are going to come out of Mexico, both on the raw materials side, on the auto parts going down, but that’s dependent on the auto industry staying strong.

So we know we had a great first quarter. We feel good about the second quarter. We may get a good surprise this year. We hope we do, but it’s really going to be based on the economy.

Bill Greene – Morgan Stanley

Okay, fair enough. And then Mike or maybe Pat, the commentary about frac sand and other parts of the business that can be driven higher due to natural gas, relative to the offset that could come on the coal side, you said you thought it would be a net positive for you.

Is that a profitability comment or is that a volume comment? I don’t know how those profitability, but we always think of coal as being so profitable, so maybe some color on that would be helpful.

Pat Ottensmeyer

This is Pat. I think it’s both. I think it’s a volume, a revenue, and I don’t see any reason why it shouldn’t be a profitability. As I mentioned, look at the length of haul improvement in the frac sand. That’s a very nice move and we can get frac sand delivered over Kansas City and in Jackson, Mississippi, coming out of Chicago or coming out of the upper Midwest moving to south Texas. That’s a nice move for us, so I think --

And then the crude oil the same. We’ll get that over Jackson and Kansas City and that’s very similar in terms of the coal in that it moves in a unit train service. I certainly don’t see any reason why the profitability on some of that new business shouldn’t be as good as the coal business.

Bill Greene – Morgan Stanley

Okay, that’s great. Thank you for the time.

Pat Ottensmeyer

Thank you.

Operator

Our next question is from Matt Troy of Susquehanna Financial. Please state your question.

Matt Troy – Susquehanna Financial

Thanks. I wanted to drill down on capex. The budget this year is 17% to 18% of revenues, in line with the industry norms, but with the locomotive going forward, it looks like you’ve got about 3% for your own disclosure associated with just buying new locos this year.

Does that imply that maintenance capex or run rate capex is something closer to 15%, 16% of revenues? Just want to get a sense of steady state, what you saw as maintenance capex going forward.

Mike Upchurch

Well, Matt, this is Mike Upchurch. The 17% to 18% we’ve kind of described as core capex requirements given our growth rates, and I think from a maintenance standpoint, we typically talk about it more in the 10% to 11% range.

The 3% that we’ve associated with the locomotives would be incremental to the 17% to 18% and is really being driven by a strong outlook on our volumes, and then certainly to some extent, the benefit that we get from a tax perspective of accelerating that into 2012.

And just to give you an idea, we’re going to be on the brink of being a cash taxpayer in the US. This bonus depreciation probably pushes us out into 2013, and there’s a nice MPV [ph] benefit per unit, almost $150,000. There’s a year one tax savings of $500,000 per unit, so there are some nice incentives to pulling that forward, and given, again, the combination of the growth profile and those tax benefits, we decided to buy those a quarter or two earlier.

Matt Troy – Susquehanna Financial

I’ve got it. The second question would be, then, on incremental margins in the 50% range. Do you feel embedded in your guidance this looks sustainable?

What headcount, what kind of incrementals can you generate through the year, and at what point would you need to add additional resources on the labor front? Is it a mid-single digit, high-single digit volume growth, as you’ve articulated in your outlook, or is there more breathing room than that? Thank you.

Dave Ebbrecht

This is Dave Ebbrecht. Let me just say that we continue to fine tune our yard and our line of road operations to achieve greater operating efficiencies. We have a lot of blocking efforts that are outlining clients. It’s been a great success as well as a greater degree of run through trains has freed up yard capacity in our general merchandise network.

This fluidity gain has allowed for an easing of access to the yards, which in turn has allowed for less time on duty and reduced now to overtime and rate crew expense, which all allows us to take advantage of our latent capacity within our current train network, so we continue to grow our headcount at a much lower rate than we are absorbing our volumes and we see that for at least the near future.

Mike Upchurch

This is Mike. Remember our guidance on headcount growth was it would be at a rate less than our volume for the year and we still very much believe that to be the case.

Matt Troy – Susquehanna Financial

Alright, thanks, guys.

Operator

Thank you. Our next question is coming from the line of Jason Seidl of Dahlman Rose. Please state your question.

Jason Seidl – Dahlman Rose

Good morning, guys. I hate to talk about something that’s going to be less than 14% of your revenues this year, but still asked [ph] a couple details on calls and majority [ph] lately in the rental space.

Pat, you corrected yourself and you added nine plants from eight and one of the plants you picked up this year. If you were to exclude that one plant from your outlook for 2Q being up, are you guys still up with your base of eight plants?

Pat Ottensmeyer

I guess I’m curious why we would exclude it.

Jason Seidl – Dahlman Rose

No, just to look at your demand for near [ph] plants from last year. I’m trying to get a sense of -- the ninth plant, you said, was -- you picked up this year, so that seems to be additional business to me. I’m trying to figure out the base demand from the plants in your region.

Pat Ottensmeyer

Yes, it would change the outlook, no doubt about it. When you take one out of nine out of anything, it’s going to change the outcomes, but I don’t understand why you would look at it that way.

Demand is low across the board because, if nothing else, because of the warm winter. But, given what we have, in terms of the business that we have in hand today and looking forward, we think it’s going to be a double-digit growth for the second quarter.

I might point out in the first quarter we had two plants that were not receiving coal, and now in the second quarter, those two plants are receiving coal, so that’s one reason that we think the needle will definitely move in the right direction in the second quarter.

Jason Seidl – Dahlman Rose

Okay. My next question is going to look at the Cross Border business. I mean, tremendous growth on the Intermodal side. Now, you guys said you’re buying some new intermodal equipment. My question is does that just accommodate the new growth that you’re seeing going forward or the continued growth to take advantage of lost depreciation, or a combination of both?

Pat Ottensmeyer

What we talked about is buying Automax equipment, which is for finished vehicles. The double-stack cars are generally furnished through trader train for all of the Cross Border.

We do have some 40 foot well cars that are captive to Mexico, which make sense for us to control and own or lease because those cars can stay within the Mexican market, but we are not buying double-stack cars for Cross Border. Those are furnished by TTA, so that’s just to accommodate, again, the finished autos.

Jason Seidl – Dahlman Rose

Okay, perfect. Listen, guys, thanks a bunch. Congratulations on a strong quarter.

Pat Ottensmeyer

Thank you, Jason.

Operator

Our next question is from the line of Ken Hoexter of Bank of America. Please state your question.

Ken Hoexter – Bank of America

Great. Good morning. Thanks for the detail this morning. Pat, when you mentioned before the Intermodal that there was a loss of a customer, can you expand on that a bit?

And then on your Port Arthur, were you suggesting that this is -- the agreement with Savage is -- are you still planning on developing the area just given the potential for the pipeline? I just didn’t understand that comment as well, so if you could expand on those.

Pat Ottensmeyer

Okay. First, the loss of the customer was in our Chemical and Petroleum business and it was a loss -- again, I guess the reason I went into that much detail, this is clearly one that cost us in terms of the volume growth that we’re reporting, and it was a significant enough customer that, as I mentioned, had we taken that out of the comps, our volume, our year-over-year volume would have been up 3% versus the negative 2% that we reported, so it was a fairly large customer.

It has nothing to do with the economy or the state of the business or the condition of our service or anything, it --

Dave Starling

Nor did we lose it to a competitor.

Pat Ottensmeyer

We didn’t lose it to a competitor. It was a function of our customer being in dispute with their customer and they literally stopped shipping. In the first quarter we saw no car loads from this particular customer.

We have heard that that dispute between them and their customer is potentially going to be resolved, so we could see that come back beginning in the second quarter, but that’s not included in our outlook for Chemicals and Petroleum.

The second question was -- What was your second question?

Ken Hoexter – Bank of America

On the Port Arthur.

Pat Ottensmeyer

Yes. No, we -- we’re still working very closely with Savage. As you may know, Savage invested a substantial amount of money building a receiving terminal in North Dakota, Trenton, North Dakota, last summer and into last fall, as did a lot of other people. If you’ve been up there you’ve seen a lot of new loop tracks going up in northwest North Dakota, and then the markets changed.

They were expecting that they would have secured long-term commitments on both the origin side and the destination side, and then with all of the pipeline announcements that started coming out in October and November, everything just came to pretty much a screeching halt.

Now people are starting to talk about, and they’re starting to move crude oil, but they’re moving it on a spot basis. They’re moving it on a non-unit train. They’re moving it in manifest service, and just to pick up on that point, if we never build the Port Arthur crude terminal, crude oil, and you’ll see it now that we’re reporting it with this kind of transparency, crude oil is going to be a very nice growth area for us, even without the Port Arthur crude terminal.

I believe that still is likely to happen, though, and the idea is that we get these customers, we get them familiar with our service, comfortable with rail, we serve them through either direct to refinery, which in a couple cases, we’re doing, or through yard capacity, track capacity, sitings [ph], any available track capacity that we have in the Port Arthur area, and that’s what we’re doing today.

And the hope is and my expectation is that as we do that, we will get some of these shippers hooked and able to get them committed to longer term contracts which will still make it possible for us to build the crude terminal.

Ken Hoexter – Bank of America

Wonderful, and if I can just throw in for Dave, you mentioned on the locomotive side, you mentioned on the employee side. Is there any crunch point on the physical network given the volumes?

Dave Ebbrecht

No, we do not see any crunch points right now. We would continue to invest in our infrastructure on our three- to five-year plan modeling and we do a lot of bottleneck analysis and looking at where we see the volumes coming, and we have a very good, methodical process for that investment going forward.

Dave Starling

This is Dave Starling. We usually have at least 2% of 3% of our capex that is set aside for capacity expansion on both sides of the border. That may be lengthening siings, adding sitings, but you’ve almost got to do that lane by lane depending on where the growth is. But we are constantly staying ahead of the capacity growth.

Ken Hoexter – Bank of America

I appreciate the insight. Thank you.

Operator

Thank you. Our next question is from John Barnes of RBC Capital Markets. Please proceed with your question.

John Barnes – RBC Capital Markets

Hi. Good morning, guys. Nice quarter. A couple of quick questions. On the Cross Border Intermodal traffic, just given the magnitude of the growth that you experienced there, can you just update it as to what you think your market share is in terms of just total Cross Border traffic with rail and truck?

Dave Ebbrecht

Well, if you -- Now that we’re given more specifics about volumes, you look at the slide that we had in here for the quarter, 9,300 loads, so that’s going to be about, if we continue to grow, call it 40,000 plus and the size of the market that we’re -- we’ve identified, I think we can go after, as we’ve said in the past, about 2.5 million truckloads. We’ve got a lot of room to grow, yeah.

John Barnes – RBC Capital Markets

Okay.

Dave Ebbrecht

That 2.5 million truckloads, as we said, that -- obviously, some of that is going to be difficult to convert some of that. That would include refrigerated and frozen products. That, obviously, is going to be more challenging, so as I said in the past, we certainly have a lot of room to grow.

We don’t feel that there are any structural or physical impediments over time for us developing the kind of market share in this cross border land that you’re seeing in some of the larger or the more mature longer haul markets in the United States, which would say that for a market of 1,000, 1,500 miles or more, you could get up into the 30%, 40% market share eventually.

John Barnes – RBC Capital Markets

Okay. Alright, that makes sense. And then a question for you again, going back on the crude by rail, I’m just curious as to understanding the price advantage the pipeline has against all other modes of transportation when you look at this type of product.

Are you somewhat constrained by how hard you can push, spot pricing right now just given if you push too hard, then it makes pipeline that much more competitively advantaged and it might even send somebody to eventually develop more pipeline and maybe strip the opportunity away from you? Are you concerned about being constrained on that side at all?

Dave Ebbrecht

No. I think that if we do this right -- I guess one of the ways I think about this, if we do this right in terms of service and pricing, I believe that crude by rail will be a product and a market that we can keep, we can retain on a longer term basis, even after the pipelines are built.

The one advantage that we have is the flexibility and the relatively low commitment and capital that is required for rail. Our rail network is already built. When we go out and talk about long term commitments with some of these customers, we’re talking about four or five years. When the pipeline companies go out and secure long-term commitments to finance their pipelines, they’re talking about 15, 20 years.

Take or pay, rock solid, so we have an advantage here in terms of offering something that is a little more flexible, and not only flexible in terms of capital and commitments, but in terms of service. This is similar to our coal business where we have multiple utilities for the same customer or our grain business where we’re serving multiple receiving locations.

One customer that we’re talking to has a refinery in Beaumont and a refinery in Baton Rouge. One of the things they like about crude by rail is that they can alter the destination and the delivery point very quickly, even when a train is in transit, versus a pipeline where you don’t have that flexibility.

So I guess long-winded answer to your question, we’re -- I think if we do this right in terms of service and pricing expectations, crude by rail is a market that will be around for a long time.

Dave Starling

This is Dave Starling. I think the other issue, too, I don’t think it’s an either/or. I think pipeline and rail actually complement each other in different ways. You actually have more demand out there today than you have capacity by pipeline and we don’t see that changing.

Even when they open a new pipeline, you still have a stronger demand than the pipeline can handle, so couple that with the fact that pipeline has a terminus point. The railroad can go anywhere our tracks will lead us, even with a connecting line partner, so we offer a lot more flexibility than the pipeline does.

Dave Ebbrecht

Just one other kind of anecdotal tidbit that supports this, if you look at some of the investments that are being made now, Enbridge, which is one of the largest pipeline companies around, is building a rail loop track in North Dakota, and on the receiving end, I can’t disclose who this is, but one of our current shippers, and one that we see growing here in the next few quarters, is a logistics company that is going to be the beneficiary of the pipeline reversals.

These pipelines are going to go directly into their network. They are building a rail loop track in their facility to be able to handle crude by rail.

John Barnes – RBC Capital Markets

That’s very helpful. Okay. Again, nice quarter, guys. Thanks for your time.

Dave Starling

Thank you.

Operator

Our next question is from Anthony Gallo of Wells Fargo. Please state your question.

Anthony Gallo – Wells Fargo

Thank you. Congratulations, as well. On the auto production growth in Mexico 2013 through 2015, can you remind us of the competitive dynamics there with other railroads who might be serving those growth markets?

Dave Ebbrecht

Generally speaking, the desired outcome is, for an auto plant, we’re talking about $1 billion, $2 billion investment. They want to be dual rail served.

In Mexico, that’s a little harder because of the way the networks were divided at the time of the privatization, but we’re going to get our fair share of the business because of where we serve on the destination side, and particularly the cross border, and our orientation over Laredo, which is obviously a much better crossing point to serve the Midwest, the Southeast and some of the growth markets in the US.

So we’re working -- Mazda right now has selected a site that’s on another railroad, but we’re working with them on service and pricing and contracts and we’ll get a good piece of that business.

Anthony Gallo – Wells Fargo

Great. And an unrelated question around Lázaro, I understand it’s supposed to have bulk commodity export capabilities. Is that still in effect for the middle of this year?

Dave Ebbrecht

It’s available now. They opened that terminal in the first quarter. They are not -- we’re not shipping any coal there. I think we will, but we’re still talking to people about using Lázaro as a port to serve Asia. Right now, the pricing is still a way off of the benchmark price, but it’s close, and if the forecast that we’re seeing for demand for coal in Asia, particularly India and China, are anywhere near close, I would expect that price is going to -- that gap is going to narrow and we will be able to move coal out of Lázaro Cárdenas.

Anthony Gallo – Wells Fargo

Would you care to tell us the dollar differential that it’s off right now?

Dave Ebbrecht

It’s within 10%, I’ll say that. It’s about 7% or 8% off in terms of the total delivered cost. That includes the price of the coal.

Anthony Gallo – Wells Fargo

Thank you very much.

Operator

Our next question is from Tyler Brown with Raymond James. Please proceed with your question.

Tyler Brown Raymond James

Hi. Good morning, everyone.

Dave Starling

Hi, Tyler.

Tyler Brown Raymond James

Hey, Pat, I had just a couple questions about your sand business. First, is that traffic largely terminating in the Eagle Ford and Haynesville? And then two, do you think that this emerging Mississippi and line point [ph] Oklahoma and Kansas may open up some opportunities for you guys? I know the rig count there has really exploded in the last six months.

Pat Ottensmeyer

Yes to both, but on the second one, it’s hard to know what that’s going to mean. We don’t have a good handle on that. On the first right now, our sand destinations are all in south, in the Eagle Ford range, Laredo, Corpus Christi, other west Texas points that we can serve through some of our short line connections.

Tyler Brown Raymond James

Okay, that’s good, and then just real quick on the Cross Border Intermodal business, are you guys seeing any real noticeable change in the willingness of your channel partners to deploy assets down there, both boxes and chassis, and then how are you helping them with any potential lane imbalances that there may be into and out of Mexico?

Pat Ottensmeyer

First question, no, we’re not seeing any change. Well, yes, we are. They’re picking up the pace. A couple of them have -- we’ve gotten no issues or no complaints whatsoever about the commitments and the actions that our major channel partners are taking to develop that business, so we’re very pleased with that and that’s obviously one of the things that’s been a factor in our growth.

Second, we’re conscious of the fact that balance is very important, so as we grow and as we convert traffic, particularly as we convert existing over-the-road traffic, we have to be fairly creative about how we look at round trip pricing and that type of thing, but I’ll say that what we’ve done so far has not caused any deterioration of our contributions, our profitability or outlook because what we’re doing is filling up capacity and adding cargo to existing trains that has a very, very small cost impact.

Tyler Brown Raymond James

Okay, yeah, that’s great color. And then just I thought your comments were really interesting about length of haul and market share. I’m just curious, how many OD pairs does your Cross Border Intermodal serve today, and then maybe what percentage of those OD pairs would be in that 1,000 to 1,500 mile range?

Pat Ottensmeyer

I think the way we look at it is by gateway because if you really go to OD pairs, we’re already talking about hundreds, particularly once it leaves our network or comes to us over Kansas City, Jackson, Meridian, those are the main gateways.

We’re moving a lot of traffic between Mexico and Houston on our network, but the majority of our growth in the Cross Border is really extending our haul to the gateways, Kansas City, Jackson and Meridian, and then interchanging with another carrier to go to a market in the Great Lakes, Northeast, Southeast, so those are all very long-haul markets.

Tyler Brown Raymond James

Okay, that’s good. Thank you.

Pat Ottensmeyer

Thanks, Tyler.

Operator

Thank you. Ladies and gentlemen, we’re about at the end of our time for questions today. We have time for one final question and that question is coming from the line of Brad Delco of Stephens Incorporated. Please state your question.

Brad Delco – Stephens Inc.

Thanks. I’ll make it quick. Congrats on the quarter.

Pat Ottensmeyer

Thanks, Brad.

Brad Delco – Stephens Inc.

Just to follow up on a question that was asked earlier in talking about the bulk facility at Lázaro, you said you expect to ship something at some point this year. I’m just trying to figure out is any of that embedded in the guidance? And if it’s not coal, what would the expectations be?

Pat Ottensmeyer

It’s not embedded in the guidance. It’s still, like I said, I believe, and I’m optimistic that I believe that we will ship coal eventually out of Lázaro Cárdenas. Again, a lot of that is based on our forecast and what we’re seeing in terms of demand for coal globally, but -- and the interest that we’re having from producers.

Think about all the discussions we’ve had about coal and the outlook for coal, utility coal in the United States. If you’re a producer, your growth opportunity is outside of this country and one of the big challenges is how do you get it on the water. So there’s a lot of interest in Lázaro, but it’s not included in the guidance that we’re giving at this point. It’s still a little too uncertain.

Dave Starling

Brad, this is Dave. I think minimally we could have an ores and minerals opportunity out of Mexico itself, and that was basically the model that was built on. At the time, they weren’t thinking to export coal, so we think we’ll have product coming out of Mexico. Of course, we would prefer for it to be coal because of the long haul.

Brad Delco – Stephens Inc.

Got you. That makes sense, but at least those discussions are being had in conjunction with your coal discussions.

Dave Starling

Absolutely.

Brad Delco – Stephens Inc.

Okay. Well, again, guys, congrats on the quarter.

Dave Starling

Thank you.

Operator

Mr. Starling, I’ll turn the floor back to you for closing comments.

Dave Starling

Okay. Thank you very much for participating in our call. It’s been a long call. Everybody’s got a lot of interest in what we’re doing. That’s very positive for us. Again, we think we’re going to have a great 2012 and we look forward to the second quarter earnings call. Thank you.

Operator

Thank you. This concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Kansas City Southern's CEO Discusses Q1 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts