Kansas City Southern Q2 2008 Earnings Call

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 |  About: Kansas City Southern (KSU)
by: SA Transcripts

Operator

Greetings and welcome to the Kansas City Southern second quarter earnings meeting. At this time, all telephone participants are in a listen-only mode. A question-and-answer session for the attendees in New York 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 event 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, 2007 filed with the SEC.

The company will not 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, Michael Haverty. Mr. Haverty, you may begin.

Michael R. Haverty - Chairman and Chief Executive Officer

Thank you very much, and I want to welcome all of you here in New York today and also those that are on the telephone and on the web cast to the Kansas City Southern second quarter 2008 earnings presentation.

Joining me today presenting will be Dave Starling who is our new President and Chief Operating Officer effective July 1, and I'll talk little bit more about Dave in a minute. Pat Ottensmeyer, our Executive Vice President and Chief Financial Officer, also available today to answer questions at the end of the presentation will be Scott Arvidson and Scott is almost a 19 year veteran with Kansas City Southern, who is Executive Vice President and Chief Operating Officer of US operations.

And Scott assumed that position in October of last year and he is the person that is most responsible for the improvement in velocity, 12 times cars online and all the metrics that we check from day-to-day. Also, with us to answer questions today will be Brian Bowers. Brian is a 32-year veteran in the Intermodal third-party sector as well as the trucking business. He is Senior Vice President of Intermodal and automotive.

We will start out on the slide that is entitled as second quarter highlights. The earnings per share were up to $0.26 over a year ago, which is an 86.7% increase. The revenues were about $59 million ahead of a year ago which is 13.8% increase. And then we had a 2 point improvement in the operating ratio.

The second quarter highlights, the results are tracking what we believed would happen in 2008 and the guidance we gave at the end of the year and also at the end of the first quarter which is inline with our five-year plan. We said in the first quarter that we would meet our 2008 plans as part of our five-year plan and we have no reason to believe that there's any change in that.

We have a lot of new business opportunities. We don't have the bubble chart that we have shown you in the past here today. But you've seen all of the new businesses that are coming online in the next couple of years and even though the economy may not be as strong as we might want it to be, there's been a lot of tremendous opportunities with the new business.

Also, our marketing people are focused on cross-border opportunities and our operating people are focusing on better and more efficient operations and under Scott's leadership as I said, he is a very process-oriented individual and we are clearly making a lot of progress in improving our metrics.

I am going to introduce Dave Starling here. Let me tell you a little bitted about Dave. I first met him back in 1980 when I was in Santa Fe in Chicago and he was superintend for Burlington Northern in Cicero, Illinois. So we've known each other for a long time. He has got 23 years in the railroad business, both at Frisco and then Burlington Northern and then with the Panama Canal Railway for the last nine years.

But he has also spent time with our partner, My Jack Products, developing their In-Terminal Services division and then he worked for American President Lines, and he was in Chicago, Atlanta, the Philippines, spent five years in Hong Kong in charge of marketing and operations for all of the Asia.

And so he has got a lot of international experience. He has got a lot of railroad experience and he has been reporting to me for nine years now. So we have got a great relationship. He actually even though he started on July 1st of this year, as President and Chief Operating Officer, for the last year he was an Executive Representative of the company even when he was President of Panama Canal Railway Company.

But we used him because we kept getting inquiries from international carriers about Lazaro Cardenas. So we got him to where he could talk about Lazaro who was our Executive Representative, so he knows a lot about Mexico. He's had a years experience down in Mexico on the intermodal side.

So with that, Dave I will turn it over to you.

David L. Starling - President and Chief Operating Officer

Let's start out talking about our operating ratio. The operating ratio for the second quarter was 78.5%, a 2 point improvement from the same quarter last year. As Mike referred to, Scott Arvidson, our leader of the US operating team and Bill Nolen in Mexico are making great strides in improving our basic operations.

Revenues have also been a great contributor to the improvement in the operating ratio, and I will get into that in a little more detail. As we have said in the past, we have been able to recover approximately 70% to 75% of the increase in fuel expense through a surcharge in rebasing of some of our contracts to account for higher prices.

Nevertheless, fuel does impact profitability. As an example, while we are pleased to have been able to lower our operating ratio to 78.5% in the second quarter. If fuel prices had remained stable year-over-year, our operating ratio would have been 75.8, 2.7 point lower than we had reported. This takes into account reduced fuel related revenues. Obviously increases in fuel price is reality, it is what it is. I only bring it up to point out that we've made great strides in improving our operations in the last 12 months.

Operating ratio trend, a longer-term ratio look at the KCS operating ratio shows continuous improvement each successive quarter given the annual seasonality in the railroad operations. If business ghost goes as we expect, we are on track to lower our operating ratio for the full year by the 1 to 2 points we laid out in the guidance we gave earlier this year and in our long range plan.

For the first six months of 2008, our operating ratio is 7.9%, this compares favorable to last year's 81.5. Through six months which landed us at 79.2% for the full year. I'd like to highlight that we have some tough comps, our operating ratio for the third and fourth quarter of 2007 were very good. The wildcard here is fuel. I am confident we will have good revenue growth and better operating performance than year ago, but we may have to work around a real fuel cost challenge. We can do it, but it will take some hard work.

Revenue growth, closer look at revenues, you can see we had a tremendous growth in our revenues of 13.8% year-over-year to $406 million, a record for our company. Total car loadings were up just over 1%, which given the US economy is impressive. Clearly though pricing elements were the principle drivers of our revenue growth.

12.2% of revenue growth pricing is due to price, approximately 7% to 8% is pure price and the rest is fuel surcharge. Second quarter brought record revenues. Approximately 4.2% of this growth is related to fuel surcharges. Looking at our book of business for the second half, we expect to meet or exceed our stated target of high single-digit revenue growth. Year-to-date revenues are up 11.7% over 2007. We also feel, we can maintain price increases in the 4% to 6% range as we have stated before. Each commodity group this quarter contributed to the revenue improvement.

Agriculture and Minerals revenue increased over 18% on pricing improvements. Volumes were flat in the quarter. However export grain looks to be pretty solid in the second half. Industrial and consumer products, our largest commodity group which includes forest products and metals was up 12.4%, primarily resulting from strength in the metals shipments.

Our customers tell us that we probably won't see a significant upturn in building materials volumes until mid-2009. The chemical and petroleum 20% increase is primarily driven by our new 15-year contract with Exxon Mobil. We are also seeing upturns in our business with other chemical customers as well.

Intermodal re revenues were up 20% for the quarter largely driven by continued growth of Lazaro Cardenas. KCS volume and Lazaro grew 44% in the second quarter. Shipments at all Pacific Mexican ports for the first five months of the year were only up 12.3%, Lazaro Cardenas is clearly the preferred port and the driver in Mexico. In addition, KCS has picked up new haulage business from the Connecting Railroad.

Overall our car loadings were up 1.1% in the quarter. This is real apples-to-apples comparison. In other words, we are not excluding any loss haulage business. This is now behind us. Industrial and consumer segment reflects growth in metal shipments. As stated earlier, we are being told by our customers that building material volume will not recover into 2009.

All volumes are down due to the loss of customer contract which we mentioned before, and also reflects some delayed traffic in the second quarter which we're already starting to catch up in July. In automotive, we are doing better than others on a relative basis, but no question the economy's impact from car sales affects us. I think it's safe to say that auto manufacturers are also in a transition period as they rethink their strategies regarding model types and retool.

In the near-term, this will dampen any volume growth, but over the long-term it could be a huge positive for us. I say this, because there is pending growth of demand for new fuel-efficient models. We understand their waiting list in some parts of the states were fuel-efficient models. In other words, there stands to be a big demand for new model. The auto manufactures just aren't at the point of satisfying that demand yet.

Revenue per car load, as you can see we have strong pricing growth across the port. Ag and minerals and industrial and consumer products benefited from strong pricing and some longer hauls. Unit trains, upper Midwest and Mexico. Steel moves from Mississippi to Mexico. Also a number of military moves in the second quarter, which is very profitable cargo for us.

Intermodal, automotive and coal improvement are primarily driven by stronger pricing and fuel surcharge revenue. The chemical and petroleum revenue per unit is pulled down by the profitable, but short haul plastic business between Baton Rouge and New Orleans. But trust me, this is very profitable and very attractive for us.

The market outlook in the second half, chemicals, metals and steel and export grain will be strong for the remainder of the year. Lazaro Cardenas will continue to grow at a substantial rate, 30% to 50% which will drive intermodal volumes.

As I noted earlier, the silver lining in the automotive is the growing demand for more fuel-efficient models. There's going to be a transitional phase however before selected plans can produce the new models, they may need to be retooled. We are confident our Mexican franchise will be a beneficiary of a good deal of this manufacturing.

Automotive is a very small market to us and that's a very small plus. We do not think it's going to grow a lot in 2009, or 2008. Coal will be somewhat stronger the second half than the first. Some weather issues affected the first quarter. In addition, some of the plants pulled down inventories. Delivery should be more normalized in the second half. Here is an example of an opportunity we have identified which is working out nicely.

In the second quarter, we signed a 15-year contract for Exxon Mobil. That business includes the development of a storage and transit yard or sit yard we call it in Baton Rouge. While this yard is under construction, the temporary storage facilities in New Orleans, this is a classic win-win for KCS it makes profitable use of an underutilized asset, our New Orleans terminal.

To improve its capacity, to meet this customers needs it is being configured to store up to 1,350 hopper cars and tanks. For the refinery it's a way to increase capacity and efficiency at their existing location. It's a perfect solution for both companies. Lazaro Cardenas, in the second quarter, Cosco and Evergreen announced that they will call Lazaro on the separate calls. Previously they shared a vessel, they also announced they plan to upsize the ships in that deployment.

APL announced a second call into Lazaro due to begin in August. Also in August, CSAV CCNI Germany's Hamburg suit that switched their services to Lazaro Cardenas from Ontario. This is great business for KCS will initially be intra-Mexico. The second concession of Lazaro is scheduled to be put of for bit in September.

Hopefully the new concession will be awarded in 2009. The second session clearly reflects a growing interest from ocean share was then utilizing Lazaro Cardenas. As we have stated numerous times while traffic in Lazaro will initially be to serve Mexican markets, we are committed to growing the cross-border business.

Victoria Rosenberg. The new Victoria to Rosenberg will be open for service in the second quarter of 2009. Open issues with bridge design and permitting that had slowed progress are now all cleared up and the project is fully under KCS control. There are three compelling reasons that make building this line an easy decision.

Number one, service. By shortening the route we are able to reduce transit time and exert greater control over train operations resulting a better service or liability. Number two, cost avoidance, just the savings alone from for shortening the route and reducing trackage rate fees more than justifies the project. Number three, incremental business opportunities. When you add the opportunities for new long-haul business and potential business online, this is a no brainier.

In June, we completed the last purchase of our 210 locomotive. This upgrade program has been completed. It has significantly increased reliability of our fleet in both the US and Mexico. The average age of the fleet has fallen from 23.2 years to 10.9. At the end of the second quarter. We are beginning to go see improved availability, 95% versus a low of 82 in 2007. Our fuel efficiency is improving and maintenance expenses are coming down.

As measured by industry fuel measurement, KCS fleet is consuming 1.18 gallons per thousand gross ton miles, down from a high of 1.33 gallons per 1,000 gross ton miles in mid-2007 an 11.3% improvement with the price of fuel is a very critical cost element for us.

Overall, the internal rate of return for locomotive replacement program is about 20%. This is causing us to retire a lot of our older locomotives as well. Our key performance measurements with Scott's leadership, over the last nine months, KCS has achieved consistent improvements in rail operations, particularly gratifying has been KCSR.

Scott Arvidson and his operations team deserve a great deal of credit for putting into place a set of key performance indicators which measure on a daily basis our operating performance. The KPIs include the chart shown here. Which are also published weekly on the internet by the AAR. These are train velocity 12 times in cars online. Our KPIs also include safety, crew availability, locomotive analysis car hailed and assorted other areas.

All of these are refined in a repeatable, measurable processes which are continually monitored and improved. These processes have gone a long way toward improving our operating ratio and will be key to our continual improvement in the future.

With that I will turn it over to Pat Ottensmeyer.

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

Okay. Thank you, Dave. And good morning everyone. Let's see, I will start here with a little bit more of an expanded view of the income statement. Recapping the highlights and looking further at the full income statement, obviously you have heard total revenues 13.8% increase from the prior year.

Operating expenses were 10.9% higher. Excluding fuel, operating expense growth was about 4%. I will talk more about expenses on the next slide. Operating income of $104.6 was up 25.8% from the prior year. We had a stronger currency gain this year because of the strengthening of the peso relative to the dollar that actually had a slight negative impact on income tax and income tax rate that I will talk about in a second.

Our equity earnings were increased, and this was driven by strong performance at PCRC and higher earnings at Ferroviaria de México, which is the terminal operation that we are 25% owner of in Mexico City. Interest and other expense was $12.1 million lower due to lower due to lower interest rates related to some of the debt refinancing that we've completed in the past year as well as lower accrual…accrued interest related to a couple of tax accruals that we settled in the quarter very favorably.

These tax related accruals represented about $9 million of the reduction in interest expense, or roughly $0.06 a share after tax. Also included in the reduction of interest expense was in both periods, we had debt refinancing-related charges that were lower in the second half for the second quarter of 2008. That, those amounts were $6.9 million in the second quarter of '07 and $5.6 million in the second quarter of '08.

So you can see it was about a is $1.5 million reduction in the cost in both periods related to debt refinancing. And then lower interest income primarily driven by lower investment balances at the related to the Meridian Speedway cash position. Income tax was much higher, obviously driven by higher pretax income. Our income tax rate was about 32.2 for the quarter. Going forward for the full year, again some of that increase in tax rate was driven by the currency gain which generates taxable income in Mexico. For the full year we would expect that the tax rate is going to be somewhere in the ballpark of 31.5.

On the operating expense side, second quarter, I think with the exception of fuel, we feel overall our operating expense performance was pretty good in the quarter. Again, fuel was up by about 38%. If you follow what's happened at the other class I railroads, you can see our increase year-over-year in fuel expense is quite a bit lower than the past so to speak, and the reason is Mexico.

Our fuel expense in the US was actually up by about 67% year-over-year and Mexico was up by only 6%. We purchased about half of our fuel in Mexico. Comp and benefits decreased actually by 200,000 in the quarter despite new collective bargaining agreements, which became effective last July. We had a slight head count reduction year-over-year of about 0.5%.

Purchased services increased by about $6.6 million, due to a number of factors including increase in locomotive maintenance expense in Mexico. Who brought in a lot of new locomotives and have maintenance contracts on those and we are still in the process of sell and disposing of the older locomotives that are going to be replaced.

We also had higher equipment infrastructure [ph], maintenance expenses and volume driven switching expense in the quarter were higher. Equipment costs another good news story here decreased by about $600,000, primarily to lower short-term equipment rents, driven and lower car hire expense driven by improved asset utilization.

Casualties and insurance increased by 1.7, but it is important to point out that we actually achieved reductions in personal injury and derailment and environmental expenses. The increase from last year primarily reflects favorable impact in the second quarter of 2007, related to reinsurance litigation settlements.

Materials and other expense increased by about $4.6 million, due to again a favorable comp in 2007, driven by a favorable sales and youth [ph] tax ruling in the quarter last year.

EPS increased by almost 87% in the quarter for the quarter versus last year in spite of a 9% increase in full year count. You can see the share count on the bottom of the slide there at 99 million shares. For the first six months, fully diluted EPS was $0.94 -- which is an 81% increase from the year earlier.

Earlier this month, we converted our series C convertible preferred stock into approximately 13.4 million common shares. Going forward, I think the common share count is going to be approximately 91 million shares. We still have a series D preferred, which adds about 7 million of potentially diluted shares and then the rest is represented by employee incentive compensation related programs.

Operating income was $104.6 million for the quarter, which was 26% higher than last year. For the first half of 2008, our operating income was 188 million, which was about 21% higher than last year.

Net income for the quarter was 55.4 by the way this is net income before preferred dividends, which is the number that we use to calculate earnings per share. Was about 83% higher. Year-to-date net income is approximately $93 million or about 78% higher than the first year.

We finished the quarter with EBITDA of $151.2 million, which was about a 16% improvement over last year. And again for the first six months, EBITDA was $281 million compared to $238 million last year, about an 18% increase.

Cash flow for the first six months of the year, as you can see was, was negative and there are couple of things I want to drill into here. Cash flow from operating activities which is the top-line here. For the first six months was only slightly higher than last year. But when you drill into this a little bit deeper, the sum of net income, depreciation and deferred taxes increased by about 40% year-over-year from $154 million last year to about $216 million this year.

As you recall from the previous slide, EBITDA which is obviously another important measure of cash flow was up about 18% year-over-year to $281 million. Compared to last year, the net change in working capital and cash capital expenditures, represents a much larger use of cash in 2008.

Reduction in accounts receivable as a source of cash was much lower than last year. However we have… currently have about the lowest DSO in, on record at KCS and we have a number of initiatives in place we expect to continue to drive cash from receivables and show further improvement in our DSO.

Higher fuel inventory and materials purchases in connection with our large capital program and increase in commodities price was also a larger use of cash this year than last year. And finally we moved several of our older locomotives from fixed assets to held for sale status during the quarter, which is included in other current assets and a reflection of the use of cash and reflected as a use of cash in net cash provided by operating activities. This will reverse itself later in the year as we sell those locomotives and generate the cash.

Looking at the cash CapEx line, much higher number this year and you remember, this number includes about $80 million of purchase locomotive in Mexico. Our original plan was to lease most of our equipment including locomotive, but due to a change in the tax law that became affective on January 1st, 2008. We made a conscious decision to purchase those rather than lease them and that is a big factor in the increase of our capital program as well as the spending that is going on in the US under the Victoria-Rosenburg line.

Here is a snapshot of our capital plan, kind of progress report through June 30th. Compared to the full year of 2007, you will recall at the beginning of the year we gave guidance on our capital program that the total capital program would be approximately $700 million, which was more or less in line with last year and the cash component of that, the cash capital expenditures would be in the range of 500 to $525 million.

We are still very comfortable with the overall size of our capital program. The cash portion will probably be at the high end of that range or possibly slightly higher as we continue to find opportunities both in the US and Mexico to take advantage of tax efficiencies caused by the, the new tax law in Mexico and the bonus depreciation in the US.

Next year, I think as we mentioned also our capital program is expected to be fairly large, kind of in line with 2007 and 2008. Debt maturities earlier this year and I will talk in a second a little bit more detail. We refinanced the major debt maturity that we have this year. The KCS railroad, 9.5% bonds. So, we have no further debt maturities this year.

The next maturity in the calendar is due in June of 2009 and that's again at the KCSR entity. The 7.5% bonds there are $200 million, we would expect to refinance that early in the year. Once we do that, all of the debt that is shown here in this chart, the floating rate debt, which is our… primarily our US bank debt, the maturity of that will automatically extend. We don't have to refinance that as long as we refinance the 7.5 bonds and that will stretch out to 2011 and 2012. So again, once we look at refinancing the 7.5% bonds, our maturity schedule is very clean for the foreseeable future.

Just a couple of highlights from a financing perspective as I mentioned earlier. We completed 275 million, 8% notes at KCSR in May, which refinanced to 9.5% notes that were due this October. That was the transaction that resulted in the $5.6 million debt retirement cost that you see in the results for the quarter.

Also as I mentioned, we completed the conversion of the 4.25% series C preferred stock in the common. 100% of the shares were converted resulting in 13.4 million common shares being issued and this will result also in an $8.5 million cash flow savings from the loss dividend.

Going forward, two transactions that we expect to complete, if not in the quarter certainly by the end of the year. We are going to replenish the liquidity in the US that we have spent on the Victoria-Rosenburg line and continue to build that, as Dave mentioned over the next few quarters. And our plans at this point I think as we mentioned in the first quarter is to put in place a bridge loan with a short-term kind of term out feature and then look at permanent refinancing options once the project is complete, including a risk loan which we think would be a very good source of financing for this project longer-term.

This quarter we will be in the market for secured financing at KCSM to again replenish the liquidity, the money that we spent on new locomotives. We have purchased and paid for new locomotive for $68.3 million. We are looking at a loan on that equipment in the range of 54.6 expect to be a 15% amortizing loan with an interest cost in the range of 6.5%.

So with that I will turn it back to Mike for some concluding comments.

Michael R. Haverty - Chairman and Chief Executive Officer

Thank you, Pat. And let me just conclude here by talking a bit about the midyear outlook. At the beginning of the year and at the end of the first quarter, we had said that we expected our revenue increase to be in the low single-digits growth. In the first half we are about 11.5% over a year ago. And in as much as the third and fourth quarter are historically better than the first and second. We have no reason to believe that our revenue increase is the second half of the year are not going to be in double-digits.

So, clearly instead of high single-digits, we will be in the low to mid double-digits. We are continuing to concentrate on long haul, cross-border traffic and to build Lazaro Cardenas business. And as you have heard that is certainly progressing. We also will continue to make operational improvements, and one of the things that we are really focusing on right now is to get orders off of the railroad particularly on the north/south line, where we hold a lot of coal and train grain traffic. And today we have maintenance… windows expect it by peak season start in October. Those windows will be off, we'll see better cycle times, the efficiency will improve and we will see better revenue on grain as we are able to turn trains more quickly and also on our coal trains.

On strategic capital, Pat talked about what our capital program is for this year and obviously last year, this year and projected next year, we are going to spend a significant amount of capital on our railroad. And that is by design, it's part of our five-year plan, when we talk about the growth opportunities that we have, we want to make sure that we have the capacity that we have the equipment, we have the locomotives to be able to meet that five-year plan.

So we will continue with an aggressive capital program through 2009. Let me wrap up here just by talking about the Panama Canal Railway Company, which Dave Starling headed and has for the last nine years continues to do well. That's one of the reasons that our equity earnings are improved in this quarter is because of Panama Canal Railway, the revenues were up 70% in the first half of the year over last year and we are operating in Panama with a 50% operating ratio.

So, while it is not a big part of your business it certainly is an important part of our business and has grown a lot greater and a lot more than a lot of people believed that it might. So with that, that will conclude our presentation here today, and we will open it up to questions.

First of all, let me have the folks move up here to the front table and I think if we have a mic , do we have a mic where somebody can identify themselves? The person asking the question can identify themselves. Please name and who you are with. Bill. Bill.

Question and Answer

Unidentified Analyst

Yeah, Jason [inaudible]. A couple of quick questions. Dave, I think you mentioned pricing was about fuels price was up 7%, 8% a quarter. It feels like pricing in 2Q for the rail industry actually got better than the first quarter. When I look at your forecast for the quarter of 6% for '08, what's it going to take to be at the low end of that range? And that seems like it's a fairly conservative estimate.

David L. Starling - President and Chief Operating Officer

Pat, you've spent a little more time working on the numbers on this. Why don't you go ahead?

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

First of all I think the 4% to 6% is more our longer-term outlook as we talked about in the context of the long range plan. I am not sure you answer that question as it relates to '08.

David L. Starling - President and Chief Operating Officer

I thought we did in the presentation, I mean we think it's fairly consistent with what we have been able to do. We don't see it changing. It is going to be as positive.

Unidentified Analyst

If I could switch to coal a little bit, you mentioned that coal is going to pick up in the second half of 2008, but still when you look at the chart you guys still have coal as a negative volume outlook. Can you talk to that a little bit?

Michael R. Haverty - Chairman and Chief Executive Officer

Yeah. Let me address that. We have already talked about a coal contract that we lost a year ago. So that's part of the overall volume, but what happens in the second quarter with floods not on our railroad, but with our connecting railroads have backed up some of the coal business. So part of the reason that you saw the volume spend in the second quarter was because of that and we are starting to pick that upright now but overall, because of the loss of that one contract, you are going see the overall volume down somewhat.

Unidentified Analyst

Last question, and I will pass it on to somebody else. What's it going to take to turn a lot of the traffic coming in Lazaro from intra-Mexico to more of the cross-border business? What should we look for?

Michael R. Haverty - Chairman and Chief Executive Officer

Well, we are now starting to get density with the carriers. I mean we have more than just the first three carriers that start their calls in August. As soon as the carrier are coming into the larger ships, and we'll see more allocation given to the US. And what we are trying to do is position our net worth. We have Dallas to Atlanta, Meridian to Atlanta with other north south route with Houston and then Kansas City that terminal is now completed, and we see the carriers… discussions with them now to do some of that conversion. Right now, the west coast is fairly fluent but we think when the west coast comes back with their age old problems that's when the real growth bridge will come.

David L. Starling - President and Chief Operating Officer

And I don't think Lazaro is any different than any other port. Ocean carriers look to distribute their containers as close to the port as they possibly can, so that they can get utilization on those assets and move them back to get them reloaded again. But when they come into a port, they then land a bridge on to the interior and that's certainly what we seen in the United States.

As the volume picks up in Mexico, clearly overtime, we will be land bridging into the United States. We need to t facility at Rosenberg to get up and going and we have talked about where we stand on that, and clearly our target markets are in the Houston area and in the Atlanta area. That's where we are very efficient there. So, I think you will see that begin to grow by the time that we get Rosenberg open next year.

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

Jason, and going back to your first question, the 4% to 6% range is what we have said as a longer-term target for the rest of this year, your specific question was what would it take to be below end of that range for 2008. We don't expect to be at the low end of the range for '08.

Christian Wetherbee - Merrill Lynch

Chris Wetherbee with Merrill Lynch. I just guess you are speaking on Lazaro for a second, could you just quantify the vessel cost. You mentioned three new vessel calls coming in starting in August. Can you quantify kind of size does that hold, and I guess percent of load that will actually be dispatched in Lazaro at least from what you have heard?

Michael R. Haverty - Chairman and Chief Executive Officer

Chris, I'm sorry I don't have the numbers with me, but so far the vessel cost in Lazaro have been more of the 2,800 to 3200T size. CSAV and CCNI are smaller carriers, their vessels won't be as large Hamburg will be a larger vessel, but really it's Cosco, Evergreen and APL and Hamburg Sud that are bigger drivers.

But they're still in the midrange. But what you are going to see is as the ocean carriers take on the new capacity, their new vessels there's a cascading event that takes place and that's when those vessels to start to get upsized. You take the 5000T vessels they replaced with an 11 or 10 and then a cascading effect. And we think we are going to see a lot of our growth through vessel upsizing more than we are through new calls is.

Christian Wetherbee - Merrill Lynch

Is that's a, kind of one to three year type of horizon or is that?

David L. Starling - President and Chief Operating Officer

Well, I worked on that side of the business 10 years. That's a tough call. The carriers go where the yield is. Right now the yield is in Mexico, that's some of their highest net cargo. So, they're clearly going saturate that market, but what you are seeing is more carriers come in than there is market size in Mexico. So, at some point that's going to start to drive up the opportunity for them, who want to go into the southwest and southeast with some of that allocation.

Christian Wetherbee - Merrill Lynch

And I think we have heard in the past that Maersk was potentially interested in doing cross border moves. Have we heard any more activity on that front?

David L. Starling - President and Chief Operating Officer

Got to be careful, I don't want to give into more strategy. Wait, I will say that there's a lot of the interest in that second concession. And APM is one of the leaders in that group. So, I think Maersk is clearly committed to Mexico. So, I will leave it at that.

Christian Wetherbee - Merrill Lynch

Just one more and I will turn it over. Just guess just Victoria-Rosenberg connector there, I don't think you've ever quantified the actual cost benefit there. Is there anyway we can put a little color around what…

Michael R. Haverty - Chairman and Chief Executive Officer

I think what we have said is, the returns on a cost avoidance basis and both point one at day five was that the project can be supported and justified just on a cost avoidance alone, with the cost being the -- obviously the track you would like to see, plus the fuel and plus the equipment cost and plus crew costs etcetera. The returns the way we look at it just on a cost avoidance are the high teens. On a internal rail return basis and that is before you consider growth. Obviously, the reason we are doing the project is, is for growth and strategic purposes as oppose to purely cost avoidance. So, we expect the returns are going to be higher.

David L. Starling - President and Chief Operating Officer

And from my standpoint transit too, its better service reliability to faster product coming out of Mexico.

Michael R. Haverty - Chairman and Chief Executive Officer

Okay, Scott.

Scott Nicholls - Gilford Securities

Mike, is there any truth that to the rumor that Union Pacific. Scott Nicholls [ph] of Gilford Securities. That the union Pacific may want to built a line from Yuma, Arizona to Pinetop [ph], which is about 150 miles south of San Diego and to develop that port?

Michael R. Haverty - Chairman and Chief Executive Officer

I think that's a question we need to ask, Union Pacific. I really don't know. I mean I have read about that for a lot of things, a lot of noise and so on, but I couldn't answer that.

Scott Nicholls - Gilford Securities

Next, what is the status of the legislation in Washington to provide the industry with a 25% tax credit. Will it ever happen? That has been going on for about 1.5 year now. It is supposed to be by part as an effort, being supported by many politicians and it never seems to be happening. Is there a problem?

Michael R. Haverty - Chairman and Chief Executive Officer

Well, I think with the election, there's focus on a lot of other different things. I think the only legislation you will probably see in the near-term on the rail side, is the safety bill that's being talked about. I just don't see, the investment, tax credit to going through probably in this session. I do think eventually that is going to happen. I think that it is going to be understood how important it is to enhance the infrastructure, rail infrastructure in North America and in the United States. And I think that will happen, but I just don't see it happening this session.

Scott Nicholls - Gilford Securities

But there's so many politicians who are supporting this legislation. Somebody has got to be stopping it.

Michael R. Haverty - Chairman and Chief Executive Officer

You know, I -- right now just our assessment is that there is just not a real emphasis at this point in time in this session on passing that at this point in time. Again I think eventually it will, but probably not in this session.

Scott Nicholls - Gilford Securities

Thank you.

Edward Wolfe - Wolfe Research

Mike, its Ed Wolfe from Wolfe Research. You just mentioned the safety bill that it might have some momentum in this session. I'm surprised to hear that. Is there anything you are sense that is…

Michael R. Haverty - Chairman and Chief Executive Officer

What the safety bill is the same that, its been discussed for some time about calculating referred to as limbo [ph] time and hours of service and so on. That may pass, but that would be the… that would be the only thing. I don't think the industry thinks that there's a huge impact as a result of it.

Edward Wolfe - Wolfe Research

But anything recent that makes you think it is going to pass? I get a sense the senate is not doing anything?

Michael R. Haverty - Chairman and Chief Executive Officer

I can't tell you for sure that, it will or that it won't, but if anything is going to pass, it would probably be that.

Edward Wolfe - Wolfe Research

Okay. Pat, on the interest in the quarter, the $9 million you referred to about the reversals and accruals. Can you talk a little bit about that and I am guessing on going, how do we think about interest is $28 million, the fair base or is this not really going forward?

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

I think you have to look at that is an unusual occurrence as it relates to tax matters that have been open for several years. So, it's not something that going to be recurring or sustainable in terms of on going interest expense. And then the other thing that impacted both of the second quarter of this year last year, is the impact of that, refinancing charges. So, we have got essentially you have got a $1.5 million savings for lack of a better word because of the reduction in the debt retirement cost year-over-year. So again, that's not something that's going to be recurring.

Edward Wolfe - Wolfe Research

So, going forward, if we look at kind of 37, 38 million, that kind of range per quarter. Is that what we should think about?

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

I think that's a good ballpark.

Edward Wolfe - Wolfe Research

Why is depreciation not going up given what's going on or you are spending more in capital?

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

Over the past year, again it is, if we have taken a hard look at both depreciation rates. We have done depreciation rate studies and overhead rate studies, so, both in the US and Mexico. So, I think we are pretty true in terms of, you know, updating both of those studies in both companies. So, the depreciation going forward should be pretty, with what you saw in this quarter.

Edward Wolfe - Wolfe Research

How many?

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

Obviously that, overtime as the capital program continues to ramp up, we would expect some, some depreciation at this point from this point.

Edward Wolfe - Wolfe Research

Roughly, how many of the 210 new locos were brought versus lease?

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

Let's see. There were, I think 60 were brought in Mexico, the 60 that we took in fourth quarter of last year and then dribbled into the first quarter of this year or the 30, that we financed earlier this year and then the 30 that came-in in the second quarter of '08.

Edward Wolfe - Wolfe Research

Dave, when we look Lázaro and talk about 40% type growth rate. It's difficult to know what that base is. When we look at the base and we say this is X percent of the total in motor volume during the motor and auto volume that break out. How should we think about what percentage, you know, what's the base of Lázaro that you are… that we are looking in growth like this also?

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

Difficult question. I'm not sure what that number is right now to base it from. We have just now baking into the first half all the new services, trying to get a feel for an allocation from the carriers. But I don't have a base number to give you right now.

Edward Wolfe - Wolfe Research

Brian, I think.

Patrick J. Ottensmeyer - Executive Vice President and Chief Financial Officer

Brian Bowers might have that number, and clearly there's no question about it. Ed, this is a start up operation down there. We really only opened, Hutchison only opened the terminal last October. So, when you talk about those kind of, increases you are talking about from the lower base. So obviously, the increases are higher. But Brian, do you have to put numbers there? The number of units handled in the second quarter?

Edward Wolfe - Wolfe Research

Maybe while you are looking at that, just conceptually in Lázaro. When you think of the three new shippers that are coming on, how much of phase I capacity is full right now and then what is phase II add when you add the new terminal?

David L. Starling - President and Chief Operating Officer

I will take that one while you are looking at. In phase I, and again we have to depend on Hutchison for these numbers, so we have to be bit careful. There's 750,000 TEUs on phase I. On phase II it is like 1.2 million, 1.3 million, and then in the phase III it's 2 million to 2.5 million. And then you have to remember the second concession is being led in September. So you know, I don't see Lázaro Cardenas being capacity constrained. You know with all of this growth coming in and the larger carriers are clearly interested in the second concession. So, it is a good story. I don't see a change in what the deepwater there, the 50 feet and potential problems in the future on the West Coast.

Edward Wolfe - Wolfe Research

Okay.

Michael R. Haverty - Chairman and Chief Executive Officer

You set the microphone, right there.

Edward Wolfe - Wolfe Research

At the pace that we have seen in growth has been accelerating pretty quickly. Through the first half of the year we had…. And we are anticipating that to grow well in excess of 100,000 units for the year, probably close to about 1,500, 20,000 units.

Edward Wolfe - Wolfe Research

And when you say units roughly, are most of them 20-foot or 40 down there?

Michael R. Haverty - Chairman and Chief Executive Officer

I would say about a 75-25 split between 40s and 20s.

Edward Wolfe - Wolfe Research

Great. Thank you very much.

Michael R. Haverty - Chairman and Chief Executive Officer

We are actually at a point now with Hutchinson [ph] where we are asking them to add more tracks into the current port, because expansion is coming, and we are kind of in a sweet spot, because we can take a lot of this capacity on by just lengthening out the train service we already have in place, because we have been lengthening our citing from Aurelio then the Lazaro Cardenas, So we are looking at this as being incremental volume added without a lot of operating costs. So we are going to be in a real sweet spot for some time.

David Feinberg - Goldman Sachs

Hi. David Feinberg from Goldman Sachs. You mentioned earlier in your comments about foreign exchange and there has been a lot of focus in terms across border-traffic that goes from Mexico to the US. I'm interested if carriers or anybody in the US manufacturing… is considering backhaul opportunities from the US and using Mexico as an export or excuse me… Lazaro is an opportunity to export to Asia or to other markets.

Michael R. Haverty - Chairman and Chief Executive Officer

There has been a tremendous amount of interest. You probably read in many of the industry periodical the availability of containers within the US is almost nonexistent for export. Their equipment is available in Mexico, and I think it is our new facility in Rosenberg opens up that would be positioned very well as one of the origin points to reload equipment back into the port Lazaro.

David Feinberg - Goldman Sachs

And primarily the interest that would be empty, there they wouldn't be actually supporting US manufacturing, they export to the lower foreign exchange.

Michael R. Haverty - Chairman and Chief Executive Officer

No, the empties, I'm just saying the empties are available in that quarter that they aren't in many others that but the interest is very high.

David Feinberg - Goldman Sachs

Great. And then maybe a general question for David. You have been on the job for 30 days, I know that's just try to go get a sense been even up to have you seen initial impressions. Maybe you can give us a sense of how you are spending your time and where you expect to spend your time.

David L. Starling - President and Chief Operating Officer

Well, first I'm very excited to have the opportunity and I certainly like the team that Mike has put together, there a lot of energy, a lot of excitement. Scott is working very hard and has been since last October on what I call the blocking of tackling just continual improvement on all processes.

With Brian on board now, we are getting a lot of our energy around the truck load market. We see that Lazaro as a great opportunity, but clearly that truck load market out of Mexico is a huge opportunity for us. So we are going to spend a whole lot of time and energy around that.

That's market. And we are to go build an intermodal network, and I see in the five-year plan it is all laid out. If you look at the five-year plan all we really have to do is execute and, we will be successful, the price of the stock will go up, and that's what we are trying to do, we are trying to get the team in place to do that.

I don't think we were spending our capital on the track as efficiency as we should and we are working on that very hard. Now we have got a new Chief Engineer has come on board, has a lot of experience. He's used to working efficiency. We are excited about that. It is an exciting time, it's a a great franchise, and I am very pleased to be a part of it.

Michael R. Haverty - Chairman and Chief Executive Officer

Also, Dave you have actually been out on the railroad quite a bit getting ready to take a trip next week as well.

David L. Starling - President and Chief Operating Officer

My nine years in Panama, I was always still somewhat involved came up for a lot of meeting. So, I have known people and they know me, on boarding and starting to work with them has been comfortable. I like the management style, it is very participatory. So I'm very comfortable here, I think we have a good future.

David Feinberg - Goldman Sachs

And maybe just one quick follow up. Any surprises or challenges that you discovered?

David L. Starling - President and Chief Operating Officer

The price of fuel. If we can overcome the price of fuel it would be a greater day, but other than that, no all of our issues are out in front of us.

Michael R. Haverty - Chairman and Chief Executive Officer

Tony?

Tony Hatch - Wall Street

Thanks, Mike. It is Tony Hatch. I just wanted to get back just quickly on the price. If you guys can look a look at this kind of different ways, what you performed so far first half and your expectations by either side of the border with the difference in the opportunities to increase the price in Mexico are and I am looking at you, Dave but I know you have been on for 30 days. Anyways the other side is particularly the intermodal side, what do you see going on in the pricing side there, and then the last question quickly is Mike, you didn't have the bubble chart in there. I love the bubble chart, and can you give us an update on the bridge losses and business developments?

Michael R. Haverty - Chairman and Chief Executive Officer

Tony, I don't have that with me right here, but we continue to pick up a lot of that business as we had projected that we would. I don't have those numbers with me. You want to answer the other question?

Brian Bowers - Senior Vice President, Intermodal and Automotive

Let me touch on intermodal pricing. We have been able to secure pricing increases in both the US and Mexico and they're holding. And I do not foresee any erosion from that in the second half. In fact there's a growing feeling that there will be a strengthening of the truck load pricing in the second half, which obviously, will have a direct impact on our ability to perhaps take more price with the opportunities there.

Tony Hatch - Wall Street

Pricing on Mexico?

Michael R. Haverty - Chairman and Chief Executive Officer

No. That really applies on both sides.

Tony Hatch - Wall Street

Okay Bill, maybe one more…or one or two.

Unidentified Analyst

Mike, Doug Thomas. I know people are so focused on quarter-to-quarter type progress, and we were talking about the second half, but Dave mentioned about the fact that what you guys have to do is really execute on this five-year plan. Maybe if you could sort of give us your impression of the highlights of what that five-year plan is from here?

Where you expect Kansas City Southern to be five years from now? Then how your incentive comp and your overall management compensation is tied to that plan?

Michael R. Haverty - Chairman and Chief Executive Officer

Well, I think we actually have disclosed that in our proxy, Doug, to some extent, at least three years out as to how we have tied the progression and success of the five-year plan to the management compensation. And we think that that is very, very important because we believe that management should do well if shareholders do well. And we're not big on perks and things like that, so we are clearly tied to that.

We think that we are on target for our five-year plan. We obviously don't talk about specific numbers, but in the past we have shown graphs, for example, that shows that our operating ratio, we expect to take it down a point to two points every year for the next five years.

And we don't see anything that would indicate to us that we are not on that plan and we are encouraged by what we see developing clearly in Mexico. From time-to-time, some people said to me, you invested in the wrong spot because everything is moving to China. Well, now people have started to say well, the transportation from China is pretty expensive for North America. So maybe Mexico is a place where some of that industry might come.

And in fact, we do have a Chinese automotive manufacturer that is moving to Morelia in Mexico right now. So, anyway, with respect to five-year plan, our compensation is tied to it. We feel like we're on it and as Dave said, our job is to execute and we intend to do that.

Okay. With that, I think we will wrap up the session. And thank all of you very much for coming in.

Operator

This does conclude today's teleconference. You may disconnect at this time. Thank you for your participation

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