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Executives

David Starling – President, Chief Executive Officer

Michael Upchurch – Executive Vice President, Chief Financial Officer

David Ebbrecht – Executive Vice President, Operations

Patrick Ottensmeyer – Executive Vice President, Sales and Marketing

José Zozaya – President, Executive Representative – KCM Mexico

Analysts

Bill Greene – Morgan Stanley

Chris Wetherbee – Citigroup

Ken Hoexter – Bank of America Merrill Lynch

Jeff Kauffman – Sterne Agee

John Barnes – RBC Capital Markets

Anthony Gallo – Wells Fargo

Tom Wadewitz – JP Morgan

Scott Group – Wolfe Trahan & Co.

Tyler Brown – Raymond James

Allison Landry – Credit Suisse

Matt Troy – Susquehanna Financial Advisors

Brad Delco – Stephens Inc.

Kansas City Southern (KSU) Q2 2012 Earnings Call July 17, 2012 8:45 AM ET

Operator

Greetings and welcome to the Kansas City Southern Second Quarter 2012 Earnings call. At this time, all participants are in a listen-only mode. A brief question and answer session will follow the formal presentation. If anyone should require operator assistance during the conference, please press star, zero on your telephone keypad. As a reminder, this conference is being recorded.

This presentation includes statements concerning potential future events involving the Company which could materially differ from the 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 website, 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.

David Starling

Thank you. Good morning and thank you for joining us for Kansas City Southern’s second quarter earnings presentation. Joining me today will be Dave Ebbrecht, EVP of Operations; Pat Ottensmeyer, EVP of Sales and Marketing; and Mike Upchurch, EVP and Chief Financial Officer. Also joining us by phone this morning is José Zozaya, President and Executive Representative of KCM from Mexico.

If you go to Page 5 on the overview, I’m going to keep my opening remarks brief and let Dave and Pat and Mike get into the specifics of the second quarter. However, I would like to say our profit in the face of the lower than anticipated utility coal carloads, some foreign exchange headwinds, and an uncertain economy, KCS had a good quarter and in certain areas a very good quarter. That we set second quarter records for revenues, carloads and operating incomes speaks to the overall strength of the KCS Rail franchise and underlines the fact that our growth story is very much intact, and that our key growth areas gained significant momentum.

For example, look at our cross-border intermodal business. In 2011, cross-border intermodal carloads increased by 56%. We were very impressed by that until the first quarter of 2012 when carloads increased by 78%. Again, we were impressed with this growth until the second quarter when the year-over-year volume growth hit 106%. It’s very exciting to see the percentage growth nearly double from 56 to 106% as the base actually gets larger.

This growth is extremely important for us for a number of reasons. First, it validates what we have said for a while now – there’s a huge market for a premium intermodal product between the U.S. and Mexico, and that market will continue to grow. KCS is in the enviable position of being the only railroad that had single-line service on both sides of the border and controlled the primary gateway between the U.S. and Mexico. We’ve invested in our network to ensure we can provide the service necessary to successfully convert a large percentage of the business from truck to rail. Now that the infrastructure is in place and our truck and rail partners are fully engaged, we’re seeing the results. And what is especially exciting, we’re still at the very beginning of what promises to be many years of expansion growth.

The second aspect that makes cross-border intermodal important to us is that it represents some of the longest haul traffic on our network, which along with the high incremental margins we’re enjoying in this business segment makes this line of business quite profitable.

I don’t want to steal all of Pat’s thunder, but by no means was cross-border intermodal the only bright, shiny object in the second quarter. Traffic on Lazaro Cardeñas remains strong and automotive continues to grow rapidly. We’re also experiencing the ripple effect of automotive growth on our other commodity areas. And as Dave Ebbrecht will illustrate in a few minutes, KCS’ operational performance continues to excel and our safety statistics just get better and better. The two really go hand-in-hand. As you have heard me say in the past, a safe railroad is inevitably a well-run railroad, and that KCS is both is having a very definite, positive impact on our profitability.

While there are certain mixed signals regarding the direction of the economy, we do feel that some of the bright spots in the economy are having positive impacts on our business. Most notably the surge in automotive sales is certainly being felt in a number of our commodity groups. More over, the very solid manufacturing numbers we’re seeing related to Mexico are being reflected in our KCS volumes. I don’t by any means want to suggest that KCS is immune from the mood of uncertainty which is prevalent regarding the direction of the global economy. We are certainly impacted by it, but there are enough positives in the economy for KCS to maintain strong volume growth in the present business environment.

We are also very satisfied with the outcome of the Mexican presidential election. José Zozaya has a good working relationship with President-Elect Peña Nieto. We believe his administration will be pro-business and we’re confident that the relationship between our company and the Mexican government will remain solid and positive.

If you’ll turn to the next page, second quarter results, I’m going to let Pat and Mike get into the nuts and bolts; but I would like to say we are certainly enjoying reporting the 62.6 second quarter operating ratio, but we understand the comparative adjusted second quarter operating ratio of 70.5, representing a 1.2 point improvement over last year, is the important number. Our second quarter adjusted diluted EPS was $0.85 compared to last year’s adjusted diluted EPS of $0.71.

If you turn to Page 7, finally despite some of the volumes and foreign exchange challenges in the quarter, KCS remains mostly on target in terms of its 2012 guidance. Year-to-date volume growth of 6% is solidly within the mid-single digit range we laid out in January. Pricing also continues to be mid-single digit. Our year-to-date revenue increase of 7% is tracking somewhat below our low double-digit projection. I will point out, however, that the combined effect of lower than anticipated coal volumes and a weaker peso amounted to a 4% negative impact on our first half revenues.

Finally, our year-to-date adjusted operating ratio is 1.9 points improved over the adjusted operating ratio for the first half of 2011, which among other things speaks to the Company’s ever-improving operating efficiencies and the overall profitability of its commodity areas. I’ll come back at the end of the meeting with a few comments on how we see the remainder of 2012 playing out and how that could transcend into 2013 and beyond; but now, let me turn it over to Dave Ebbrecht.

David Ebbrecht

Thanks, Dave. Turning to Slide 9, I want to start out by emphasizing the importance of our safety efforts at KCS and the value it has provided for the Company. We’re very proud of the recognition of our best-in-class safety award of May. Not having injuries, not having accidents and not having derailments is not only great for our employees and the public, but it also adds value to the bottom line. Our injury claims are down 43%, total liabilities down nearly 60%, and our total casualty expense is down 60% compared with the same period in 2008 when we had higher headcounts and higher train activity. Recognizing that the cost of failure in our business can be expensive, we continue to improve our standards in the future and ensure safety is at the forefront of every decision.

Turning to Slide 10, I would like to re-emphasize our consistent ability to control costs. As you can see, ops costs, 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 line haul revenue. Our judicious expense management and cost control in these areas continues to be a major driver of our OR improvement.

On Slide 11, you can see our headcount controls are still improving with growth. As I stated last quarter, we would see as seasonal dip in this efficiency metric due to the 13,000 less carloads shipped from the fourth quarter to the first quarter, but it would return to greater efficiency in the second quarter as carloadings improved. We still expect our efficiency to trends upwards throughout the year as our headcount will remain relatively flat in the future.

On Slide 12, you can see our operating metrics continue to remain in a very good range for the second quarter. Velocity continues to be strong, averaging above 27 miles per hour. Dwell and car efficiency showed very good trends of fluidity with the increased volume handled. A slight uptick in maintenance away slow orders is due to the heavy maintenance away activity on the Shreveport and Saltillo subdivisions, but the slower track speed has had no material impact on velocity and dwell. Our main message from operations is that we will continue to scale costs well below volume and revenue growth projections.

Now I’ll turn it over to Pat for sales and marketing.

Patrick Ottensmeyer

Good morning, everyone. I will start my comments on Slide 14, which shows revenues, volumes and RPU by major business unit. As you can see overall, revenues were 545.3 million, a record for any second quarter and 2% above last year. Volumes increased by 4%, average RPU declined slightly, which was a function of mix. As you’ll see later, the very rapid intermodal growth had impact on that revenue per unit. As you’ll also see in a moment, adverse foreign exchange movements reduced our revenue growth by about 3% during the quarter.

I’ll go quickly through the business unit details. First in the chemical and petroleum business, as we explained last quarter, one of the major contributors to the decline was the loss of one petroleum move due to a dispute between one of our customers and one of their shippers. This impact continued in the second quarter and represented about 3 points on volume and revenue for this business. This customer is beginning to gradually return in the third quarter, and the comps for the rest of the year should be pretty positive in this business.

The industrial and consumer growth was driven largely by strength in metals and paper. It’s worth noting that we saw some strength in our lumber and building products business during the quarter, still nowhere close to where it was a few years ago but the trends certainly look good. Ag and mineral revenue and volume were lower than last year, due in part to tough comps as the second quarter of last year was the best ever in this business. Additionally, we did lose some cross-border business: a corn syrup move that went through a facility that we don’t serve, and then another loss of a cross-border customer due to an explosion at one of their facilities that we serve. This facility will be back in service in September and we’ll begin to see that business come back into the fourth quarter.

I’m going to skip the energy business and we’ll cover that in more detail in a minute. The intermodal business unit broke records across the board. Second quarter revenue, RPU and volume were all records. As Dave mentioned, our cross-border business continues to be very, very strong, and I’ll talk more about that in a minute. Automotive revenues were higher than any prior quarter in spite of a fairly significant negative foreign exchange impact. Revenue would have been up 33% and RPU up 13% if the foreign exchange rate had just been flat from last year. Automotive cross-border revenue continues to see double-digit increases, and I’ll talk more about the longer term outlook in the auto business in a few minutes.

Moving to Slide 15, you can see the factors contributing to the change in revenue; and as I mentioned, the decrease in utility coal and the weakening of the Mexican peso created headwinds that cost us about 5% revenue growth in the quarter. Volume growth and increase in fuel surcharge revenues contributed 10 million to the revenue growth. Rate and mix were positive as well. We continue to see core pricing in the mid-single digit range as we have reported in the past.

If you look at Slide 16, this shows average daily carloadings by month since the beginning of the year. There are a couple things I would like to point out on this slide. First, you can really see how strong January and February were versus last year. As we mentioned last quarter, it feels to us that some of the unusual strength in the first quarter pulled some business ahead and out of the second quarter, which kind of explains how we got off to a little bit of a weaker start in April and May in addition to the impact of the utility coal. The second point on this slide is that you can see the trend is increasing steadily over the course of the second quarter and actually hit record levels in June, where we showed an 8% higher average daily carloadings than last year. The acceleration throughout the quarter was driven primarily by utility coal, but we saw strength in industrial and consumer and intermodal and automotive as well.

Slide 17 shows the moving pieces in our energy business unit. As was the case in the first quarter, our coal volumes dropped primarily due to the warm spring weather across our region, extremely low natural gas prices. In fact, our utility coal volumes are up further from the first quarter levels. As you will see on the next slide, however, we are seeing improvements in utility coal volumes from the low point in March. Frac sand continues to somewhat offset the loss in utility coal. Crude oil is also growing from a small base. The frac sand business grew about 60% from the second quarter of last year, and crude oil shipments grew by over 100%. Unlike the first quarter, however, the frac sand and crude business did not offset the decline in utility coal.

As I mentioned earlier, we believe that utility coal volumes hit bottom in the spring and we have seen, as you can see on Slide 18, steady improvement every month since March. While the extreme heat we are experiencing across most of the country and most of our service regions should drive some increase in demand, the continued low price of natural gas and relatively high coal stockpiles will likely keep volumes from growing further from these levels. As much as I should avoid making predictions about the future of the coal business, especially after being pretty far off last quarter, it feels like the worst is behind us and volumes should continue at or near June and July levels going forward through the rest of the year.

The next slide, Slide 19, shows our cross-border revenue, which was down slightly from the first quarter but 2% above last year. Factors contributing to the sequential decline include low cross-border grain shipments, lower food products volumes, which was the corn syrup business that I mentioned earlier, lower DDG volumes. In addition, I mentioned earlier that we lost some cross-border business due to an explosion at one of the grain facilities that we serve. If we had moved this business during the quarter, our cross-border revenue growth would have been 4% higher than last year. Also as I mentioned, this facility will reopen in September and overall we expect to see cross-border volumes increasing over the course of the year. I think the key point here is that our cross-border growth story remains very much intact and the business will continue to show a long-term positive trend line, but there will be occasional dips driven by seasonal factors and customer-specific issues.

The next slide, number 20, shows intermodal growth, cross-border growth. What is remarkable here is that the base is growing and the growth rates are actually increasing. Since we opened the Victoria Rosenberg line in mid-2009, our cross-border intermodal volumes and revenue are both about five times higher than they were before in just a little over three years’ time. All of our key asset partners are highly engaged in seeing outstanding results. Our top six customers all recorded double or triple-digit volume and revenue growth from last year.

As Dave mentioned earlier, the punch line to this slide is that the network is in place, our key partners and customers are very highly engaged, the market is huge, and we have very low market share at this time. This business is well positioned for strong growth for a long time to come.

Moving to Slide 21, you will see the Lazaro Cardeñas growth story remains strong as well. Volumes and revenue were up by 20 and 30% respectively. The revenue growth was driven primarily by the volume, but we also had strong core pricing growth during the quarter for our international business.

Moving to Slide 22, this is where I’ll take some heat from the first quarter guidance. I’m sure you all remember we guided to low double-digit growth for the quarter, and low double-digit growth in the energy business unit. Well obviously, that did not happen. As you can see on this slide, we are now guiding to mid-single digit revenue growth for the full year. Early in the year, we were assuming that the peso would remain stable at about 12.9 per U.S. dollar. In late May, the exchange rate climbed to over 14, and June ended with an average of right at 14. This deterioration in the peso will cost us about one point of revenue growth for the full year.

Additionally, the reduction in fuel prices will drive our revenue forecasts down another point. We expect fuel prices for the remainder of the year to decline by approximately 10% in the United States and 2% in Mexico. As we have stated in the past, and this is a very important point to reinforce, neither fuel nor foreign exchange have much of an impact on operating income or operating ratio as the expense savings is almost equal to the revenue loss.

The bigger factor in our revised guidance is utility coal, and I think that story is pretty well understood at this point. Based on the best information we have from each of our utility customers at this point in time, which is a very big disclaimer, our current coal forecasts will take two full points off of our full-year guidance. I think this reconciliation is pretty simple and straightforward, and as you will see flipping to the next slide, the change in our guidance is really isolated to the energy business, and more specifically to utility coal. With the exception of energy, the full-year guidance for every other business unit is exactly the same as it was at the end of the first quarter and pretty consistent with what we are seeing on a year-to-date basis.

Our chemical and petroleum business is slightly negative year-to-date, but the recovery of the cross-border customer that I mentioned earlier and other factors should produce improved comps for the rest of the year, so we still feel that it will be positive for the full year. Industrial and consumer will continue to benefit from strong metals and paper and hopefully some continued strength in lumber and building materials. At this point, we still feel that the ag business will be positive for the full year, but we are very conscious of the impact of the weather and the drought in the midwest; and depending on how that continues, the outlook could change. Most of our growing region, which is in Iowa and Nebraska, is still okay. Missouri and further south is very dry and the crop is not in good condition. It’s also important to remember that most of our cross-border grain is driven by human consumption, and we feel that that will create some stability in the demand side.

As I mentioned earlier, the energy outlook has been adjusted to reflect the year-to-date results and the latest information available from each of our customers. We continue to expect significant growth in both our intermodal and automotive business, so when you put all this together, we are currently expecting full-year line haul revenue growth to be in the mid-single digits from 2011.

Moving to Slide 24, I’ll make some comments about the broader outlook for our business. First, we are expecting positive economic environment in both the U.S. and Mexico for the rest of the year. Second, we see no fundamental change in our pricing outlook and are quite comfortable continuing guidance in the mid-single digit range. At the risk of being burned again by coal, we really believe that the worst is behind us, at least in the short term, and we would see volumes and revenue stabilize at recent levels going forward. I’ve already talked about the cross-border growth outlook for intermodal, and I think the numbers there speak for themselves.

Our longer term new business pipeline continues to grow. With the exception of the coal business, the emerging energy markets driven by the abundant supply of natural gas and crude oil in North America will provide attractive growth opportunities. In frac sands, drilling price crude oil, we are seeing these markets grow already, as you saw earlier. In addition, as we stated last quarter, we believe sustained low natural gas prices will drive growth in ethane and ethylene-based production in products like polyethylene. Over the last year, companies such as M&G Polymers, Chevron Phillips, Formosa Plastics, Dow and others have announced plans to build new production facilities in the Gulf region. While it’s too soon to know what these announcements will mean in terms of volume, revenue and timing for us, we feel this will be an important growth opportunity for KCS given our position in the region.

I’d like to spend a little more time on the longer term outlook and update you on some of the automotive business since there is so much activity right now in that area. The short story is this – based on new auto plants being built in Mexico, finished vehicle production is expected to grow by more than 30% from current levels over the next four years. Automobile production has a large freight ripple effect with parts, steel, plastics, soda ash for glass, et cetera. And finally in the case of KCS today, the majority of our auto-related business moves only on our Mexican franchise. Over time, we expect to move more of that traffic on our own cross-border network to markets and gateways that we serve in the U.S.

Moving to Slide 25, you can see our network with the existing and new auto plants shown. I’ve highlighted the three new plants currently under construction for Nissan, Mazda and Honda. Combined, these three plants will have an annual production capacity of more than half a million vehicles. A fourth plant for Audi has been announced but the details, including exact location and production capacity, are not currently known.

Moving to Slide 26, based on those new plants and expansions underway at other facilities, finished vehicle production is expected to grow from about 2.5 million units last year to 3.5 million in 2015, a 40% increase over 2011 and more than 30% increase from current production levels.

And finally on Slide 27, I mentioned the large freight ripple effect that’s driven by finished vehicles. This slide puts that into a little better perspective. Driven largely by the increase in automobile production, we know of five new steel plants and processing centers that are also under construction in our service region. It’s again too early to know what this will produce in terms of volume and revenues, but it will represent a significant growth area for us in the future. It’s difficult to quantify precisely how big this ripple effect is, but our automotive and auto parts business is about 12 to 13% of our total revenue; and when we add steel, plastics and other products, we believe our auto-related business will be in the mid to high teens. Again, the market is going to grow by more than 30% from current levels, and our growth will also be driven by how successful we are in driving a higher level of cross-border business.

And with that, I will turn it over to Mike Upchurch.

Michael Upchurch

Thanks Pat, and good morning everyone. I’m going to start my comments on Page 29. Pat’s already covered revenues, so let me focus on operating expenses and a few of the below-the-line expenses.

Operating expenses in the quarter did include the benefit of a reversing a net deferred liability resulting from an organizational restructuring, and as we previously reported during our first quarter call, the net benefit results from the reversal of our profit sharing liability and represents a one-time credit of $43 million, which is net of transaction costs. On an adjusted basis, year-over-year operating expenses were essentially flat, and I’ll provide you with more color on that in the next few slides.

Interest expense declined to 25.3 million or a reduction of 22% year-over-year, and since our peak annual interest expense back in 2009 we have been able to reduce interest by approximately $74 million, a more than 40% reduction. We did experience a $3.5 million foreign exchange loss during the quarter as a result of the peso deterioration. The FX rate was 12.8 at March 31 and closed the second quarter on June 30 at 13.7.

We incurred a $5.9 million charge for debt retirement costs which relate to the refinancing of our 8% notes, and as a reminder, the annual interest expense savings from that refinancing we expect to be about $17 million, and we should exit 2012 with interest expense of about $100 million.

Income tax was 53.1 million in the quarter for an effective rate of about 31%, and I’ll explain our lower than expected tax rate in more detail in a few slides. Reported EPS was $1.09, and that does include the one-time deferred liability reversal of 43 million and a $5 million debt retirement charge; so on an adjusted basis, our EPS was $0.85, which was an increase of over 20% over a year ago.

On Slide 30, you can see our total adjusted operating expenses were essentially flat year-over-year. Our volume-sensitive costs such as crew labor, fuel and car hire were up about 6 million. Fuel price increased 3 million year-over-year, and inflation increased our costs by approximately 6 million, and then we did benefit by 14 million from the decline in the peso. And as Pat already mentioned in his materials, revenue declined by 15 million so we essentially had minimal impact to operating income due to foreign currency fluctuations.

On the chart on the last equipment expenses, we’re down 3 million year-over-year and that’s due to the locomotive lease that we acquired. We acquired those assets back in the third quarter of 2011, and that has contributed to about a 50 basis point improvement in our operating ratio. Purchased services increased 5.5 million largely due to volume-related increases in our intermodal business and the timing of track maintenance related expenditures. I’ll cover comp and benefits and fuel on the next two pages.

So turning to Page 31, comp and benefits expense increased slightly year-over-year to 106 million, and as you can see on the chart on the left-hand side of the table, headcount declined during the quarter, demonstrating again that our operations team continues to do a great job managing our cost structure. Incentives and other went up 3 million, and we did experience a $4 million benefit due to foreign currency. Just to give you a little perspective on full-year, we do expect our total comp and benefits to be up only 2% over 2011 despite volume increases and inflationary cost pressures.

Turning to Slide 32, from a fuel perspective, fuel did decline 5 million year-over-year largely due to foreign currency. While our reported price per gallon, as you can see on the left-hand side of the slide, declined to $2.78, the FX adjusted price was actually 2.97. During the quarter, our lag benefit due to the falling diesel prices was approximately $2.5 million, and while our carloadings were actually up 4% year-over-year, our fuel consumption actually declined due to the commodity mix issue that Pat discussed earlier. For those of you keeping track of gallons and prices during the quarter, in Mexico we consumed 15.7 million gallons at an average price of $2.49, and in the U.S. 15.5 million gallons at $3.08.

So now let me on Pages 33 and 34 cover our taxes in a little bit more detail. On Page 33, this chart reconciles our U.S. statutory tax rate of 35% to our effective rate of 30.5 for the quarter. Our effective tax rate for 2Q of 30.5 was lower than originally projected and is the result of two discreet items – the changing FX rate and a tax valuation allowance credit we recorded during the quarter. Let me walk you through the chart from left to right and explain how we ended up with a lower tax rate.

First, state taxes and other increased our tax rate by 3.8% - that’s on top of the 35% federal statutory rate. Second, as you know, the FX rate has improved from 14 at the end of 2011 to now a projected 13.5 for the end of 2012. Again, based on Mexican tax law, when the peso strengthens it theoretically requires fewer pesos to extinguish our U.S. dollar denominated debt that we have in Mexico, and that creates an unrealized income and a resulting non-cash tax expense, and in this case specifically adding 3 percentage points to our tax rate. As a reminder, our general rule of thumb is that a 10 basis point change in the exchange rate equates to about a 50 basis point change in our tax rate, so you can see the roughly 3 percentage point increase to the statutory rate.

Next, GAAP also requires us to true up taxes for the first quarter since we booked a rate in the low 40s, and we now expect our full-year tax rate to be somewhere in the 36 to 38% range. So this changing tax rate estimate is fully explained by the improving peso since first quarter, and we booked a credit that reduced our rate by 2.4%.

Next, the statutory rate in Mexico that we pay taxes on is only 31%, so below the U.S. rate; and based on our pre-tax income mix, this had the impact of reducing our consolidated tax rate by 3.3%. And finally, we reversed a $9.8 million tax valuation allowance representing state tax expense that we had recorded in prior periods. This valuation allowance was related to state NOLs that now have more certainty of being utilized since we have a clear history of using these NOLs over the past few years, and we also have more certainty in utilizing the NOLs going forward, and the $9.8 million reduction to tax expense does represent real economic value to us.

Turning to Slide 34 to provide some additional color on the volatility of the peso and the impact to our tax rate, I wanted to highlight how the deterioration in the exchange rate drives the effective rate down and vice versa. Hopefully, you can see in this chart the peso was relatively stable prior to fourth quarter 2008, as was the resulting effective tax rate. So on the green line, you can see the peso began to deteriorate, driving down our effective rate depicted by the blue line as Mexican tax law again provides the deduction relative to our U.S. dollar denominated liabilities. You can continue to see this inverse relationship of FX and tax rates since the end of ’08, in some cases driving our tax rate up and in some cases driving our tax rate down. But of particular importance if you look at the table that we have in the slide on the bottom right, you can see our expectation over a five-year period, while there is some volatility in each year, that the net of that has been about a $1 million tax expense and it’s largely been non-cash.

We will continue to evaluate the risks and benefits of attempting to hedge currency, but we haven’t made that decision at this stage and we’ll likely evaluate that as we become a cash taxpayer.

Finally on Slide 35, we did generate 57 million of free cash flow year-to-date. As we’ve communicated in the past, our priorities for cash have generally been to de-lever the balance sheet, invest in our business, and provide for shareholder return. Having largely completed our deleveraging and debt restructuring goals by calling the 8% notes in June, our focus will begin to shift on investing in our growth opportunities and providing for returns to our shareholders.

You can see we’ve significantly reduced our interest expense through a combination of debt reduction and refinancing activity, and we believe we fully have credit metrics that meet the criteria of an investment-grade company. While our core CAPEX spending continues to suggest a CAPEX to revenue ratio of 17 to 18%, we’re fully committed to continuing to invest in our business to achieve a superior growth profile, and accordingly we do expect to take delivery of some incremental locomotives by the end of the year which should add somewhere between 2 to 3% to our CAPEX to revenue ratio. It’s also important to note that that would allow us to take advantage of the 50% bonus depreciation rules that are in effect through the end of this year.

Also during the quarter, we continued to evolve our strategy of acquiring assets under lease and turning those to ownership, and we’ll continue to do that and the total outlays during the quarter were 20. Some of the commitments we made will take that to $23 million.

And then finally, our Board of Directors approved the Company’s second quarter dividend which was paid on July 6. Our yield continues to be slightly above 1%, and that’s a level that we are comfortable with at this point.

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

David Starling

Thanks, Mike. If you’ll turn to Slide 37, I’ll talk about Panama Canal Railway (inaudible). There were some labor issues at the Pacific port in Panama. There was a strike. It was resolved, and then there were a few days of strike again. That’s now been resolved, but it did affect volumes and create congestion in the port, which we are currently sorting out. Our run rate is already improving in this quarter. As you can see, it caused a slight deterioration in the operating ratio down to the low 50s – still, not a bad performance.

In the closing remarks, I’d like to end with just a couple of comments about our immediate and long-term future. While we don’t profess to have any special ability to predict the economy, it feels to us that the second half of 2012 will be okay. There is certainly a fairly high degree of uncertainty out there, and while the majority of our customers think they’ll experience some level of growth in the back half, everyone is being very cautious. Though hardly a valid sample size, our carloadings through the first few days of July would suggest our customers are correct and that business will be okay.

It certainly appears that the worst may be over this year as Pat spoke about coal. Of course, right now with the blistering heat in our region, the coal burns are quite good. We’re going to have to wait to see where natural gas prices are later in the year when temperatures moderate. Currently, natural gas pricing is moving toward a level which would make PRB coal price competitive, but we’ll have to see how that market develops over the next few months. The rest of our commodity groups look like they’ll be fine, and in some cases like intermodal and automotive they’ll be more than fine.

In terms of revenue guidance, two things which are beyond our control could continue to exert influence over revenues. The peso-dollar exchange rate could either help or hurt revenues. In the second quarter, FX exerted downward pressure, but we’ll just have to wait to see what happens during the rest of the year. Also fuel expenses have definitely moderated – that’s a good thing for us, but it certainly appears that you won’t see as much fuel surcharge revenue in our numbers. As Pat and Mike both mentioned, it is important to remember that while both FX and fuel surcharge can impact our top line, they do not have a corresponding impact on our profitability. In terms of FX, we have a good natural hedge that, for the most part, neutralizes the impact of currency fluctuations. In terms of lower fuel costs, while it may lessen the revenue number, we will benefit from the lesser expense.

In the end, while we believe our second half volumes will remain steady or may even improve, the impact of the second quarter lower than anticipated coal volumes and the possible future impacts of foreign exchange and lower fuel prices will likely lead to our 2012 revenue percentage increase, as Pat stated, to fall into the mid-single digits. However, no matter what the impact of these items on the revenue line, barring any kind of significant event, we believe we can continue to improve our operating ratio and overall profitability during the second half.

Our final word about the future – we feel that 2012 will be a very good year for KCS. The first half was good and we feel the second half has the potential to be even better. We have always looked at 2012 as a bridge year. Developments in nearly all of our commodity segments suggest that growth could and should accelerate in 2013 and 2014 as new auto and steel plants come online, our new energy opportunities are realized, and our intermodal business continues to expand and mature. To sum it up, we at KCS feel very, very good about our future.

And with that, we’ll open it up for questions.

Question and Answer Session

Operator

Thank you. We will now be conducting a question and answer session. [Operator instructions]

Our first question comes from the line of Bill Greene with Morgan Stanley Smith Barney. Please proceed with your question.

Bill Greene – Morgan Stanley

Yeah, hi there. Good morning. You know Dave or perhaps Mike, just a couple of questions around some of the labor stuff. We have the new labor deal. I thought it was going to have a bigger impact on the P&L, the way we view the labor expense, but maybe I didn’t understand that. And within that, can you talk a little bit about maybe the productivity because, Dave, I think you mentioned the industry-leading productivity, but how much better can that get? What annual were in you in there?

Michael Upchurch

Dave, do you want to start with the productivity?

David Ebbrecht

Sure. On the productivity side, our headcount controls will continue to be flat, and we still have a lot of latent capacity within our train network, especially in Mexico, to grow within our current structure. So I don’t see any degradation at all in the productivity, and we’ll continue to see modest gains as our growth continues.

Michael Upchurch

And Bill, this is Mike. With respect to what you may have had in your models for second quarter, I think it’s remarkable we kept our overall comp and benefits expense pretty flat on a year-over-year basis, and the guidance I gave for the full year is that our comp and benefits would only be up 2% and that has to cover certainly volume increases and inflationary cost pressures. But I think a combination of the efficiency that Dave talked about some of the reductions in our overall incentive-related expenses that we’ve already covered really help. And keep in mind that we took the credit all in a single line item, so it didn’t all run through comp and benefits.

Bill Greene – Morgan Stanley

Okay, okay, got it. And then Dave Starling, your last comments just about your forward outlook, when you’re referring to growth, were these comments largely focused on volume or was that sort of an earnings comment? I just want to make sure we interpret what you’re trying to say there correctly.

David Starling

Well if Pat does his job properly, we better have the revenue with the growth! No, I mean, when you get into the automotive industry and the growth in the intermodal, we certainly see volume growth, but with that, good revenue growth will go with it. And I think our ability to continue to leverage the network and the efficiencies we have are going to still make that bottom line look even better. I mean, we’re still able to onboard more volume at a very good margin.

Bill Greene – Morgan Stanley

The incremental should keep these sort of levels we’ve seen, in other words?

David Starling

They should.

Bill Greene – Morgan Stanley

Okay. All right, thanks for the time.

Operator

Thank you. Our next question comes from the line of Chris Wetherbee with Citigroup. Please proceed with your question.

Chris Wetherbee – Citigroup

Hey, thanks. Good morning. Maybe just a question on the cross-border intermodal. I think you mentioned that it’s up 5X from the opening of the Victoria Rosenberg extension there. I guess I just wanted to get a sense, first of all, kind of what you think the potential capacity is – you’re expanding your reach further into the U.S. – as far as incremental volume growth as we go forward.

Patrick Ottensmeyer

Chris, this is Pat. Your question is what capacity issues do we expect to have?

Chris Wetherbee – Citigroup

Do you have capacity issues going forward, or what is the level of capacity you might have for further growth?

Patrick Ottensmeyer

We’ve got a lot of capacity in terms of space on the trains we are running today. One of the things we’ll have to do as we continue to extend our reach and increase the volumes over our gateways is add service, but we try to really stay ahead of that both in terms of terminal capacity, network capacity. You know, look three or four years out – you’re familiar with some of the investments we’ve made in the terminals in Mexico. That’s all with an eye toward looking at our volume projections and the increases, and staying well ahead of any potential bottlenecks, whether it’s locomotive, whether it’s line capacity, whether it’s terminal capacity, chassis’. You know, there are a lot of things that could provide bottlenecks, and we try very hard to understand where are all those are and make sure that we’re ahead of them as we bring the volume on.

David Starling

Chris, this is Dave Starling. Let me give you just a couple of examples. We talked about how we model the capacity and continue to expand. We’re already pulling our 2013 expansion at the Monterey facility into 2012 because of the volume growth. We are in the second year of laying 136-pound welded rail between Laredo and Monterey – that’s a four-year project. We can accelerate it if we need to, but that will give us a 79 mile-an-hour railroad between Monterey and Laredo, so we are very consciously continuing to expand. Our commitment to Pat is, it’s there, fill it, we’re not going to restrict it. So we’ll continue to spend the money necessary and have the focus on that corridor to make sure we can handle the growth, because a lot of that growth, the automotive growth, will be in that same corridor.

Chris Wetherbee – Citigroup

Okay. And so it sounds like that has the potential to lend itself to existing train starts, at least for the time being, so that the space is available on the existing trains that you’re running as opposed to incremental train starts for the most part?

David Starling

Pat has more space to fill.

Chris Wetherbee – Citigroup

Okay, fair enough. And then one quick question on the auto side – you just mentioned about the fact that most of that is currently running kind of on the Mexico specific side of the network. I guess what are the barriers to extending that into the U.S. and really doing it on a cross-border basis? Is it just waiting for existing contracts to kind of renew, or is there anything else to think about there as far as allowing that business to flow across the border more freely?

Patrick Ottensmeyer

The primary gating factor is contracts. I mean, it is—the bulk of that business is under contract. Obviously when we look at the three new plants or four new plants that are being built, there are no contracts; so in that case, it’s a matter of getting those plants up and running and producing. That cross-border business will be available to us when those plants open, but a lot of the automotive business is locked up under contract and another piece of it is just continuing to improve the service options and getting the service together to get to the markets that we need to serve beyond just the KCS network.

But the shortest answer and the best answer, really, is that business is locked up under contract, in some cases out to 2017.

David Starling

And in some cases, some if it is actually up for bid as we speak.

Patrick Ottensmeyer

Correct.

Chris Wetherbee – Citigroup

All right, so it’s a rolling process.

David Starling

That’s right.

Chris Wetherbee – Citigroup

Great. Thanks for the time, guys. I appreciate it.

Operator

Thank you. Our next question comes from Ken Hoexter with Bank of America Merrill Lynch. Please proceed with your question.

Ken Hoexter – Bank of America

Great, good morning. Just trying to dig into your decreased revenue outlook a bit. Can you walk though—are the utility customers now accepting coal again? Is that issue—you know, the two plants that had stopped for a while, can you walk us through an update on that?

Patrick Ottensmeyer

Yes. Every utility we serve is now taking coal. Some of them still have very high stockpiles in spite of the fact that the heat is really causing the plants to all run at pretty high levels. But every one of our plants is now taking coal; and again, at the risk of being wrong twice, I’m just telling you exactly what we’re hearing from our customers, and what we’re hearing is that they expect—probably the best chart in the deck, in my opinion, is the one that shows the average daily carloading for the coal business. You can see how far that fell off in March, April and May, and where it’s come back to. And what we are hearing is that the expectation is that we will be in that sort of high 600, low 700, the range that you see in June and July for the rest of the year.

David Starling

I might add, too, that we have one coal customer that their contract will be up for renewal at the first of the year, so they’re expecting a rate increase and we expect them to have as much coal delivered as they can possibly stand between now and the end of the year.

Ken Hoexter – Bank of America

Okay. And then can you talk a bit about yields, kind of the optics of mix shifts that you experienced through the quarter with the growth of intermodal autos. You know, compare that will what you expect on the underlying—you know, just again trying to dig into this decreased revenue outlook.

Patrick Ottensmeyer

Ken, really I’ve said it, and if you look at the two slides – and I don’t want to oversimplify it, but the decreased revenue outlook for the year is a function of the energy business. Every single business unit, if you go back to the first quarter presentation that we gave you, every single business unit other than energy, the outlook is exactly the same as it was at the end of the first quarter. Obviously the peso has an impact, and fuel; but as far as the core business, the only one that has changed from what the guidance we gave in the first quarter is energy.

Ken Hoexter – Bank of America

So Pat, on that, are there corresponding costs that you can pull out as well, or is it moving equipment around that? How can you—

Patrick Ottensmeyer

That’s the other thing, and I guess going back to—before I forget. I mean, you saw revenue per unit decline. We’ve kind of been saying this for the last couple of years that you might see some odd things happening in our revenue per unit as our intermodal business grows. And you understand, the RPU for the intermodal is different that it is particularly for coal, where what you saw happening in the second quarter was a huge kind of flip between coal and intermodal which drove the outcome in the RPU. We don’t think of revenue per unit as yield. You guys talk about it as yield – we really don’t think of it as yield because of the way the mix is going to change that. So we’re getting increased yields in intermodal as we add more containers to the train. That basically falls almost 100% to the bottom line, so as we build density and we build capacity on those intermodal trains, the profitability impact is going to be very positive.

On the coal side, again, to see the kind of drop-off we saw in the coal business during the quarter and still show the kind of operating ratio improvement, and we’ve also talked about this – as you know, how the coal business runs, it’s all unit trains and the equipment in our case is—100% of the equipment is privately owned, so we don’t pay that cost. When we have the kind of reduction that we had in the coal business, unlike general merchandise or even intermodal, we have an immediate cost avoidance in terms of fuel, crews, locomotives, everything else, so the scaling that Dave Ebbrecht talked about in terms of the lost coal business is probably better and more immediate than it is in any other business unit.

Ken Hoexter – Bank of America

Very helpful.

Michael Upchurch

And Ken, again – this is Mike Upchurch. Just to make one additional comment, despite the challenges in volume and on the coal side of the business, we improved our operating ratio on a year-over-year basis and sequential basis. That should tell you something about the ability to manage the costs.

Ken Hoexter – Bank of America

Certainly. Thanks, Mike.

Operator

Thank you. Our next question comes from the line of Kevin Crissey with UBS. Please proceed with your question. Kevin Crissey with UBS, your line is live.

I’m sorry. Our next question comes from the line of Jeff Kauffman with Sterne Agee. Please proceed with your question.

Jeff Kauffman – Sterne Agee

Thank you very much, and thank you for clarifying the tax differences with the peso so clearly. Wanted to ask two different questions. The first is we’ve had record heat in a lot of your service regions. How does excessive heat affect your ability to operate?

David Ebbrecht

Well the excessive heat, first of all, creates some conditions on the track with the rail temperature that we do have to monitor and we have to patrol ahead of some trains in some instances where we have to take precautionary measures. Other than that, the excessive heat does not pose immediate threat as far as just pure train operations, other than from a safety aspect of keeping the crews hydrated and making sure that we are conducting a consistent and safe operation.

Jeff Kauffman – Sterne Agee

So maybe run slightly lighter, slightly slower?

David Ebbrecht

Well, we do have heat orders where the track heats up, then we will place heat orders on those when the rail temperature’s in a certain range, until we can verify the track is stable. And when it stays above that temperature, we’re able to take those off; but we do go through a transitional period where we do have to run slower, especially down on our Laredo sub and sort of our hotter areas during that transition period.

David Starling

This is Dave answer. I think one answer would be if you look at our service metrics today, you have not seen a deterioration, even with the consistent high heat.

Jeff Kauffman – Sterne Agee

No, that’s what I was referring to. I’m a little surprised by that, but that’s great. A second quick follow-up is grain. You know, with the corn crop at 31%, I think you alluded to looking okay but let’s watch this for the second half. What percentage of your grain business is cross-border today?

Patrick Ottensmeyer

Oh, I have that handy here. It’s a large portion of our business. It’s probably in the high 40% range, close to 50%. That’s by far the biggest segment of our cross-border traffic today is grain.

Jeff Kauffman – Sterne Agee

Okay. And if for whatever reason the yields are poor—I mean, high corn prices are great for the farmer, but that’s going to be bad for volume later this year. Is the volume more at risk going to be the chickens in Arkansas or is it going to be more the cross-border grain moving down to Mexico?

Patrick Ottensmeyer

Well, I wouldn’t say that there’s a different risk factor in either of those, but the thing we kind of believe about our grain business is because so much of it is based on human consumption, people will still want to eat and chickens will need to be fed, that what might happen even if prices are on the rise, that we have to draw from a broader region. But our end consumers will still need the grain, and we think that gives us a little more stability in our business than might otherwise be the case if we were selling into the world market and the prices would push that U.S. grain out of the market.

Jeff Kauffman – Sterne Agee

Okay, well thank you and congratulations.

Operator

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

John Barnes – RBC Capital Markets

Hey, I want to follow back up on Jeff’s line of question around grain. Am I thinking about it right, if grain was to be weaker in the back half than expected because the crop yields come in light, is it similar to your coal franchise in that a lot of this stuff runs in unit trains, and if the volumes were to come in lighter, you could more aggressively attack the cost structure around that than if it was weakness in your general merchandise business?

Patrick Ottensmeyer

Yes. I mean, all of our cross-border gain moves in shuttle service, which is very similar to the coal business. The only main difference would be the equipment cost, the car costs. We own a large percentage of our grain cars, which is different than the coal business, so our cost avoidance would not be exactly the same, but fuel, crew, locomotives – all of that, we would stop immediately.

John Barnes – RBC Capital Markets

Okay, very good. And then going back to your comment around capital expenditures, I think you highlighted that you expected to still run at a similar pace or percentage of revenue that you’ve seen in the last several quarters. I’m just kind of curious as to is there a cliff that you’re finally getting to, or are you getting closer to maybe completing a lot of the projects that would have kept that elevated, and what we’re seeing now is that number still is up there because you are pulling forward? What I’m asking is, are we getting to a point where maybe that begins to ramp down by a couple of percentage points and we start to see more free cash flow generation?

David Starling

That’s a CEO question – I’ll take that one. You know, we are long-term players. We’ve been in this business 125 years, and we owe it to our customers to have a good railroad. We owe it to our customers to have plenty of capacity for their expansion, and with the growth story that we see for our railroad in 2013 and 2014, the worst crime we could commit for a shareholder or our customers is not have the capacity to handle it. So I do not see us backing off of our 17 or 18%. We’ll continue to have the 10 to 11 for maintenance, but I think capacity expansion with our growth story is always going to be forefront in my mind of making sure that we have the capacity to grow.

Michael Upchurch

Hey John, this is Mike Upchurch. I know you made a mention on free cash flow and generating more free cash flow. I might just make one clarifying comment there – while we reported 57 million for the year, and you may be looking at our investor report and see 92 there a year ago, I think it is important to understand that we initiated dividends this year, which we didn’t have last year, so that may have negatively impacted some comps. We also did a $23 million lease buy-out, and then a year ago of the 92 million, we had 30 million related to insurance recoveries sitting in there. So when you kind of look at it on a run rate basis, we’re really over 100 million year-to-date and about 60 a year ago, so that’s a pretty substantial increase in free cash flow.

John Barnes – RBC Capital Markets

All right. Thanks for the clarification there.

Patrick Ottensmeyer

To go back to specify the answer to the question on cross-border, it is 48% of our total ag and mineral line haul revenue cross-border.

Operator

Thank you. Our next question comes from the line of Anthony Gallo with Wells Fargo Advisors. Please proceed with your question.

Anthony Gallo – Wells Fargo

Thank you. Good morning. First, a housekeeping question, a bigger picture question. Mike, what was the effective tax rate that you used in the $0.85 adjusted EPS number?

Michael Upchurch

We used the statutory rate there.

Anthony Gallo – Wells Fargo

Which was what?

Michael Upchurch

About 38% or so on, you know, combined state and fed.

Anthony Gallo – Wells Fargo

Perfect, thank you. And then a bigger picture question here, and I appreciate the encouraging comments you gave with respect to all the organic growth opportunities, which we certainly buy into, and the encouragement that you find in your customer discussions about a decent second half. But can you just remind us the two or three things that you watch internally and how quickly you can make adjustments to the extent that the macro picture deteriorates from here? Thank you.

Patrick Ottensmeyer

I would say the most important thing we look at—you know, obviously in the coal and grain business, we kind of talked about that, and we get pretty good visibility from our customers what to expect. But I think the most important thing is feedback from customers, and we really try to keep our fingers on the pulse and actively engage in dialogue and outlook. When we do our forecasting and projections, we do it based on customer-specific. The top 200 customers in U.S. and Mexico represent over 80% of our total revenues, and we build our forecasts and our projections on customer-specific input for each of those.

Anthony Gallo – Wells Fargo

And then the adjustments that you can make and how quickly you can make those?

David Starling

Well, this is Dave Starling, and I’ll let Dave Ebbrecht speak to this as well. I think if you sat through our morning call and listened to the 80 people that are on the call in the U.S. and the second call at 8:30 in the morning, we’re in a very unique business. We know what our loadings were through yesterday. We know our customer orders. We know how many cars are stored. We know the turn times, the availabilities; so I’ve got to give Dave Ebbrecht and his team great credit. I mean, they are on top of it every day, and those decisions on whether to furlough crews, to put locomotives in what we call surge storage to start to adjust our costs can happen very quickly.

David Ebbrecht

Yeah, and I’ll just add when we look at 48 hours out, 72 hours out, that’s how we adjust very quickly and nimbly to changes in demand, and then we look at some synergies that we can get to extend those changes and make sure that we have cost savings that go well beyond just a short term and extend through the rest of the quarter.

David Starling

The paper mills, for instance – we know when their maintenance shutdowns are going to be from a week-to-week basis. We know if they delay one, if the orders are great. We know if they pull it forward, or they’ve either got a machine problem or their orders have dropped. It’s really a pretty unique business in knowing what our customers are doing and the forecasting. If they don’t order the cars, if they don’t provide us the forecast, we may short them cars; so we get great information from our customers.

Anthony Gallo – Wells Fargo

That’s really helpful. Thank you, gentlemen.

Michael Upchurch

Anthony, Mike Upchurch. Let me clarify that comment on the tax rate. Even though I just told you in the slide that the statutory rate in Mexico is lower than the U.S., I answered that with a U.S. statutory rate so you should look at a 30% rate.

Anthony Gallo – Wells Fargo

Oh, it was 30%?

Michael Upchurch

Yeah, yeah. I apologize for that.

Anthony Gallo – Wells Fargo

That’s important. Thanks, Mike.

Operator

Thank you. Our next question comes from the line of Tom Wadewitz with JP Morgan Chase. Please proceed with your question.

Tom Wadewitz – JP Morgan

Yeah, good morning. I think the first one I have is a question for Dave. You commented before we got into the Q&A about 2012 is a bridge year and 2013 and 2014, you would expect stronger revenue growth, and I think Pat gave more detail on some of the drivers behind that. How would we think about three utility coal and FX impact? I think you were saying, you know, like 10, 12% of revenue growth this year. How do you think about the range that you get to when you’re beyond this bridge year? Is it 15% revenue growth, or what—you know, based on the information you have, is there any kind of range you can put us in for 2013, 2014?

David Starling

I’ll take a shot at that and then hand it over to the marketing guru here. We are spending a lot of time right now with the three customers in Mexico that have already committed to building auto plants – some are already under construction. I think it’s a moving picture right now. Some of the customers, some of the plants will service the U.S. and Canada. Some will actually go both directions – they’ll actually export through Lazaro to Central and South America. I mean, Mexico is a very unique geographic location that can serve markets in both directions, and then there’s also that growing middle class in Mexico itself. So that is a real tough question for us. I mean, Pat’s trying to quantify it, trying to put those numbers together. The operating guys definitely want them so we can still plan our capacity correctly, but I would say it’s still kind of a moving target. I know Pat’s done some work on trying to quantify the associated products that we enjoy as a result of manufacturing an automobile, and I know he’s taken a shot at it but we have not made it a science yet. I’m not sure we ever will.

Pat, you want to take a shot from there?

Patrick Ottensmeyer

The only thing I’d say, Tom, is what we’re trying to convey here is really that the outlook is very good for continued new business opportunities and new business growth for us, given our unique position and competitive advantage in Mexico. We haven’t quantified beyond this year. We’re really in the early stages of our planning and forecasting for 2013 and beyond. We’re trying to get more precise information, as Dave mentioned, from the auto companies, so we’re at the beginning of that process. At this point, I don’t think we are prepared to quantify what that growth rate range is, but the overall sort of big picture is that it looks very good.

David Starling

Yeah, I’ll add a couple more comments. We had breakfast with the CEO of Ternium in Mexico a couple of weeks ago, and the new plant that’s going to be built in Monterey, I think it’s over a billion dollars they’re spending in this plant. And I didn’t realize how much of the U.S. market that plant will serve. We just kind of assumed it was going to be for Mexico auto manufacturing and the growth of manufacturing in Mexico, but they clearly see the U.S. and Canada. It’s already a market for them. In fact, they actually have distribution centers in a couple of places in the U.S. already. But they clearly see themselves providing product going into the U.S. and Canada. And then we’ve got chemical plants that are going to be built on our system in the U.S. Railroads would get excited about an automobile being built on their system every couple of years, every five years. We’re going to have four in two years, so this is pretty dynamic.

Tom Wadewitz – JP Morgan

Okay, great. That’s helpful. One more question along that theme – Pat, you gave us some helpful detail here on the steel plants. It looks like these are relatively near term in terms of end of ’12 and into 2013. Is there a framework for—you know, you’re saying 3.5 million tons of added steel. How much steel runs on your line today, or how many carloads? Because I don’t feel like I have a good feeling for what the base is when we consider the 3.5 million tons.

Patrick Ottensmeyer

Yeah, I’d like to kind of hold off on giving any more specific guidance, again, as Dave mentioned, until we get a better handle on what these customers are expecting in terms of volumes and rail market share and routings and everything else to give maybe in the future some better guidance about what we think is going to do in terms of our own growth outlook.

Tom Wadewitz – JP Morgan

Okay, fair enough.

Patrick Ottensmeyer

And the other thing I’ll mention – some of these are mills, and some of these are processing centers so that’s important. As you look at the details on the slide, the Di Acero, Ternium and Steel Technologies in the north are new mills, and these are huge facilities. As Dave mentioned, each one of them is over a billion dollars of investment for the producer. Some of the others are processing centers. They will generate freight. You’ll have a coil going to a processing center to be stamped into an auto part and then moved to the plant, so we’re still trying to sort out exactly what this means in terms of our own outlook for volume and revenue.

Tom Wadewitz – JP Morgan

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

Operator

Thank you. Our next question comes from the line of Scott Group with Wolfe Trahan & Company. Please proceed with your question.

Scott Group – Wolfe Trahan & Co.

Hey, good morning guys. How’s it going?

Patrick Ottensmeyer

Good. How you doing, Scott?

Scott Group – Wolfe Trahan & Co.

Good. So wanted to ask a question on coal. Pat, when you talk with your utility customers, what’s the gas price that you think you need in order to see some more switching back to coal? And then what’s the explanation you’re getting from your customers on why we’re going to see this continued strong run rate that we’re seeing in June and July, and why it won’t drop off again in the fall when we get to the shoulder months?

Patrick Ottensmeyer

Well, if you look at the run rate, I mentioned high 600, low 700s, right around there. You know, that’s greatly improved from the spring but it’s still below the shoulder month last year. Just to go back and tick off your questions, what we’re hearing—and it’s different plant by plant, but what we’re hearing is gas prices kind of in the 3.50 and higher, our coal plants and our coal business will do pretty well. We’re below that now. Right now, everything is firing because of the intense heat, and everyone is taking coal; so when the temperatures moderate, if gas prices are where they are, we might see some drop-off at a couple of plants.

David Starling

And regulated and deregulated makes a big difference as well.

Patrick Ottensmeyer

Yeah – it makes a difference by market, by plants. The cost structure of the plants are different. What else was I going to say? Lost my train of thought.

So I think the levels we’re at now, while they are improved from the spring, still below last year. We have some other things – Dave mentioned the fact that one of the coal moves that we’re in is going to be—it’s a joint line move with another western carrier. Our rates are set, and to provide a little bit more clarification to the point Dave made, our rates are set for this move going forward but the originating carrier bringing the coal to Kansas City, that contract is up for a renewal at the end of this year, and they are expecting the rates will increase and they are building a stockpile to the sky in anticipation of those rates increasing. So we’re seeing some unusually heavy movement for the rest of the year as they build their stockpile in anticipation of a rate increase.

We won’t see that rate increase because this is what’s called a Rule 11 rate, where the rate for the two railroads are set separately directly to the customer. Our contract is not going to be affected, but the overall cost to the utility will be.

Scott Group – Wolfe Trahan & Co.

Okay, that’s great color. Thanks. And then the second question on Lazaro, can you talk about the timing for the new concession opening up, and then what percent of the current concessions are being utilized? Is there need for the second concession yet where we see kind of an immediate volume benefit, and then maybe longer term, how does the opening of Panama Canal impact Lazaro and then the company overall?

Patrick Ottensmeyer

Okay. Second concession was awarded in December, and as we understand it, all of the paperwork and the contracts and the agreements were signed in June. The concession was awarded to APM Terminals, which is an affiliate of Maersk Lines. The current concession, there’s only one concession operating at Lazaro today, and that’s Hutchinson. Hutchinson is running probably about—it’s a moving target, because they’re running about 65, 70% of capacity, but they’ve got a footprint and they are continuing to increase capacity. They’re adding paving, they added a new berthing crane earlier this year, so they are in the process of taking their capacity to roughly 1.5 million. They think the footprint that they have and the design that they have will allow them to build to about 2.2 million, so that capacity is going to continue to increase at Hutchinson.

We met with APM earlier this year. They have an exact—the exact same footprint in terms of the size of the property as Hutchinson has, but they are going to design it differently and they think they can get capacity to something like 2.5 to 3 million once they are fully built out. It’s going to take years to get to that level, obviously. What we would expect, and Dave knows the lay of the land better than I do in terms of the way this rolls out generally, but we would expect that initially some of APM’s growth will come out of Hutchinson but that over time both of them will grow. I guess the important thing is we’re serving a port that has been the fastest growing container terminal in North America the last couple of years, and it’s going to go from something around 1.2 million TEUs today, and the capacity is on the board to go to 4.5 to 5 but that’s going to take several years. The good news is we are maintaining our market share at Lazaro in the 65 to 70% range versus truck, and as you know, we’re the only railroad that gets there.

David Starling

I’ll add to Pat’s comment – generally what happens when you open a second port concession is there is a deterioration in the rates. You now have a competitor, so the rates will be more competitive—or the ocean carrier, not our rate. So the ocean carriers will have a little bit of leverage then because they have a two-port opportunity, and the company that may lose on that would be the Manzanillo International Terminal, that is the older facility. This will give the ocean carriers a little bit of chance to leverage into the new concession and get out of Manzanillo.

The question on Panama, we get this frequently. The opening of the Canal should cause the pie to get bigger in Panama. You can bring in bigger ships. That’s more opportunity for trans-shipment. We are a cost avoidance model in Panama, and I think recently when they had the labor problems there, it created some congestion; and the ports right now are—there is a lot of growth in Panama, and they are realizing that they need more space and that they need more berths. So the government in Panama is now working on a U.S. model of adding another port on the Pacific side called Corazel, which is adjacent to our railroad. That could be a new modern facility that would be added to the Hutchinson facility. And at the same time, the ports on the Atlantic side, there is a new concession being discussed – I forget the name of it – but it’s east of the Evergreen facility by a couple of companies. They’ve come to us for service, so there’s still more growth that’s going to occur in Panama because of the third set of locks – again, just more ships, bigger ships, more opportunity for trans-shipment.

On Lazaro Cardeñas, the effect on a canal with Lazaro, it’s a different market. Generally all you will see on the ships that in that deployment is maybe a stop in Panama to load or unload, but generally that allocation coming out of Asia and Mexico is for that market. We’re starting to get some inquiries as well, more inquiries that we’ve had in the past about the U.S. market. I think some of it could be related to the noise on the east coast about the potential strike, so we’re getting some inquiries for cross-border.

Scott Group –Wolfe Trahan & Co.

All right, that’s great color. Thanks, guys.

Operator

Thank you. Our next question comes from the line of Tyler Brown with Raymond James Financial. Please proceed with your question.

Tyler Brown – Raymond James

Hey, good morning guys. I’ve got just a couple quick cash flow questions. Mike, I know you’ve gone over this in the past, but can you refresh us on your cash tax paying status, both in U.S. and Mexico, given the NOL revaluations? Does that lengthen the non-cash tax paying status?

Michael Upchurch

Yeah, it’s a different answer in Mexico and in the U.S. We are probably on a trend right now that by the end of the year, we could become a cash tax payer in Mexico, and then 2013 in the U.S. So we will have utilized the majority of our NOLs.

Tyler Brown – Raymond James

Okay, perfect. And then just to clarify on the CAPEX, so is the guidance 17 to 18, or is it 17 to 18 plus the 2 to 3 for the locomotive pull forward?

Michael Upchurch

It’s plus the 2 to 3, so look at a number roughly 500 million.

Tyler Brown – Raymond James

Okay, perfect. I’ll just leave it at that. Thanks.

Operator

Thank you. Our next question comes from the line of Allison Landry with Credit Suisse. Please proceed with your question.

Allison Landry – Credit Suisse

Thanks, good morning. So I was wondering if your outlook for non-coal energy has changed in light of lower oil prices. It looks like the pace of growth in frac sands slowed a little bit in the second quarter relative to Q1, and I was wondering if maybe that was a sign that drilling activity might be slowing down.

Patrick Ottensmeyer

A bit, although what we’re seeing is that the pace of activity in the two—the Eagleford region and the Bakken region is still pretty high. We’ve seen more of a drop in activity in the Haynesville, for example, where there is a much higher percentage of dry gas versus oil. But the outlook really hasn’t changed. Still feel that the growth there is going to be very strong for several years to come, and then the ripple effect I think we talked about in the first quarter of these chemical—these ethane, polyethylene plants, that also looks very good. Based on what we have heard on production values or production estimates for most of those plants, any one of those could produce rail volumes equal to or larger than a coal plant.

Allison Landry – Credit Suisse

Okay, that’s really helpful. And just following up on that question, you mentioned earlier that crude and frac didn’t quite offset the decline in coal this quarter, so I was wondering if maybe you could speak or provide some color behind the relative profitability of crude and frac versus utility, and if you think that the expectation for continued growth there could offset the utility volume declines in the second half.

Patrick Ottensmeyer

Sure. All of those businesses are very attractive, high profit, high contribution business, and so the answer is we’re not diluting any of our contribution or operating ratio or profitability by shifting from utility coal to frac and crude. The second quarter—if you look at the first quarter, the offset was almost even. Utility coal was down and frac and crude were up by about the same amount. Utility coal, as you saw in the presentation, was weaker in the second quarter. We don’t expect that to happen, so it’s hard to know but I would expect maybe the offset would be closer to what we saw in the first quarter than what we saw in the second quarter going forward.

Allison Landry – Credit Suisse

Okay. Fantastic. Thank you very much.

Operator

Thank you. Our next question comes from the line of Matt Troy with Susquehanna Financial Advisors. Please proceed with your question.

Matt Troy – Susquehanna

Yeah, I just wanted to touch on Mexico given the strategic significance to your network, specifically in light of the change in the administration. If you could just maybe refresh us where your primary points of contact are, your stronger relationships, your dialogue with the outgoing administration, and where some of those relationships may change and what your engagement with the incoming group has been like so far.

David Starling

José, if you’re still on the call, would you like to take this question?

José Zozaya

Yes, Dave, of course. The new administration – every six years when the administration changes, most of the top officials of the administration leaves the office. The ones that are directly related to us is the SCT, equivalent to the transportation board in the U.S., and the secretary. The new or the potential candidate to become the new secretaries of the SCT in Mexico are people we know and we have worked with them in the past five years, so we have a good and close relationship with most of them. Of course, nothing is certain until they are named for that position. And we have worked very—as Dave mentioned the beginning of the call, we have been working with the new president for six years now when he was Governor of the State of Mexico, very close, and we are confident that he will continue the way he was as governor, promoting for investment and supporting private business.

Matt Troy – Susquehanna

Okay, so what I’m hearing loud and clear is that the line of sight visibility into the people with whom you’ll be dealing with, and also good working relationships which span years, ergo we should not expect any significant change.

José Zozaya

That’s right, exactly.

Matt Troy – Susquehanna

Okay, thank you. The second question I have – just more broadly as we think about rail property, (inaudible) coal domestically, you know, this is a property and what are, I think, in terms of expectations over time gravitate towards an OR in the mid-60 range over time. Is that something that is still attainable in, let’s call it a three to five-year time frame? Do you not manage it that way, or just what’s—you know, when you think about the dart board on a multi-year planning basis, is that’s something that’s reasonable or within your goalposts?

David Starling

You know, I’m going to take this one, make this statement I’ve continued to make. We’re going to continue to grow our revenue and control our costs and improve our operating ratio on a year-to-year basis. Certainly we’ve said in the past, we want a six in front of the number. We feel like we’re headed in that direction, but we have not set any goals to say we’re going to be at 65 by some year. We’re going to continue to work on it. We don’t see any major obstacles. We set a goal before of 1.5 points every five years, and then we did—or every year, and then we did 10 points over a five-year period. So again, goals are good, but we’re going to continue to run our business and make the right investments and the right decisions, and I think the operating ratio will demonstrate that.

Matt Troy – Susquehanna

Excellent. Thanks for the detailed answers, guys.

Operator

Thank you. We have time for one more question. Our last question comes from the line of Brad Delco with Stephens Inc. Please proceed with your question.

Brad Delco – Stephens Inc.

Good morning gentlemen. I’ll make this quick. I guess it’s a question for you, Mike. If you look at your equipment, locomotives, I know you guys have taken some equipment off lease. How much more of that is available, or maybe asked another way, how much of the equipment you currently have is leased versus you own?

Michael Upchurch

Yeah, our ownership of equipment is in the low 20s. We think that’s too low; we’d like to migrate that up over a period of years, but understand we have a lot of equipment under lease, long-term lease. And as they come up, we do engage in discussions with the lessors to try to attempt to buy that equipment to the extent we think we’ve got a use for that equipment for a number of years. And then certainly anything new, we’ve had a bias towards trying to purchase either through a financing or with cash and own the asset. I think you’ll see us continue to do that and chip away at maybe what’s a slight disadvantage today from an operating ratio perspective compared to the other railroads.

David Starling

I think, Brad, if you look at our goals that we have set over the years, it’s certainly to become investment grade. It’s to push our maturities out at a lower interest rate and also in that list is a conversion from lease to own. We’re at 20%, as Mike said; the other railroads are about 50%, so we certainly are making decisions now that when the cash is available, rather than lease we’re going to purchase. But we don’t—you know, that’s going to be a long-term opportunity for the Company.

Brad Delco – Stephens Inc.

Got you. And then Dave, if I could just ask you one question because everything I’ve heard on this call, it’s long-term growth sounds very good, particularly in Mexico. You know, the way that I thought about it, or think about it, and I’d love to get your thoughts – if Mexico is really where the growth is, I think you have some sort of—you have a cost advantage there relative to the U.S. You still have a lot of low-hanging fruit with the leased fleet that you can convert to owning. It seems like not only the top line should accelerate but there’s still good, very clear ways to improve the OR. How do you think about the balance between growth in Mexico versus U.S. and what that could do to your margins?

David Starling

Well again, we’ve always stated that we have opportunities in Mexico. We’ve made it very clear we do have a lower cost structure there, but on the labor side we’re working very well with labor but there is opportunities where we can create win-wins for ourselves and labor where we don’t reduce any jobs, we just grow, and that’s a big opportunity for us. We’ve got another maintenance contract coming up this year that we’re reviewing that would be a fourth quarter event that we’re taking a hard look at, which would be another legacy contract that we can come out of. So we’ll continue to do that, and I do agree with you and still stand by the statement – I think we do have more opportunities for leverage and upside of revenue in Mexico.

Patrick Ottensmeyer

Yeah, just a couple of things to tack onto that. Don’t lose sight of the fact that this, as I referred to the new energy market, is going to provide a lot of growth opportunities in the U.S., then go back to my comments on the auto industry. We have auto and intermodal, we have a significant opportunity to increase the U.S. side of some of that business by using our U.S. network, and that’s going to produce a lot of efficiencies in terms of longer length of haul, and that’s generally going to help the profitability on the U.S. side of the equation.

Brad Delco – Stephens Inc.

Very well. Thanks, guys, for your time.

Operator

Thank you. Mr. Starling, I’d like to turn the floor back over to you for closing comments.

David Starling

Okay, thank you very much. Thanks for joining us. We will see you in the third quarter.

Operator

Thank you. Ladies and gentlemen, this concludes today’s teleconference. You may disconnect your lines at this time. Thank you for your participation.

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