Canadian National Railway Company - Q2 2017

Transcript

Operator (participant)

Welcome to CN Second Quarter 2017 Financial Results Conference Call. I'd now like to turn the meeting over to Mr. Paul Butcher, Vice President, Investor Relations. Ladies, and gentlemen, Mr. Butcher.

Paul Butcher (VP of Investor Relations)

Thank you, Patrick. Good afternoon, everyone, and thank you for joining us today for CN's Second Quarter 2017 Earnings Call. I would like to remind you about the comments already made regarding forward-looking statements. With me today is Luc Jobin, our President and Chief Executive Officer; Mike Cory, our Executive Vice President and Chief Operating Officer; JJ Ruest, our Executive Vice President and Chief Marketing Officer; and Ghislain Houle, our Executive Vice President and Chief Financial Officer. In order to be fair for all participants, I would ask you to please limit yourselves to one question. I will be available after the call for any follow-up questions. It is now my pleasure to turn the call over to CN's President and Chief Executive Officer, Mr. Luc Jobin.

Luc Jobin (President and CEO)

All right, thanks very much, Paul, and welcome everyone to our Second Quarter Earnings Call. Well, today, the CN team is pleased to report another very strong quarter. Our performance was driven by a sizable increase in revenues, building on volume momentum, which started in the fourth quarter of 2016. Our growth in the second quarter was also broad-based and achieved across most business sectors, translating into an 18% rise in RTMs. Meanwhile, we maintain our inflation plus pricing discipline. JJ will give you more color on our record quarterly revenue performance and a sense of what's in store for the second half of the year. From an operating standpoint, Mike and his team worked very hard to accommodate this level of growth while staying true to our commitment to balance service and efficiency.

The result is evident in our operating ratio of 55.1%, up only 60 basis points versus last year, and our record operating income in the quarter. Looking at the bottom line, the strength of our quarterly financial results speak for themselves. Diluted EPS of CAD 1.36, up 24%, adjusted diluted EPS of CAD 1.34, up 21%, and solid free cash flow generation of CAD 811 million in the quarter. Ghislain will expand on key financial highlights for the second quarter on the call and later today, and address as well our outlook for the year. Let me now turn the call over to Mike, who will give you a sense for how the operating team has brought on board the substantial volume increase we've experienced thus far this year while maintaining our industry-leading performance. Mike?

Mike Cory (EVP and COO)

Thank you very much, Luc. And first, let me just say happy anniversary to the team here in the room for a very successful first year together. Overall, I'm extremely proud of the operating team's performance in this quarter. You know, it's really a testament to their execution of our operational and service excellence agenda. Our volume, our volume growth in this quarter has been the largest in my 36 years at CN, and who would have ever forecasted a 175% frac sand increase in one quarter? But that's not the entire story. This increase is broad-based across business segments and operating regions. As a result of the volume increase, on top of attrition, we are hiring for all the operating groups.

With new skill set demands that the evolution of PTC, technology, and automation bring, our attention to proper onboarding and integration is greater than I have ever experienced. I'm really proud of what this team has accomplished so far, and it's a testament to the culture of excellence that we've created, that we're able to manage this type of growth and change environment and produce very solid results. So let's take a look at those results. The volumes of 2016 provided an opportunity to reduce people and assets. Most roads, if not all, saw the benefit of added capacity to more experienced workforces, line and terminal space, and less unproductive assets in the mix. Train speed, terminal dwell, fuel, and locomotive productivity all improved as a result. So for context, I'm using a similar volume period against the same infrastructure backdrop.

Actually, my comparison of 2015 isn't exactly that, as workload or GTMs were 6% less in 2015 than they are in 2017. 2014 is actually a truer comparison, workload or GTM-wise, but we did make infrastructure improvements in 2014, or excuse me, in 2015, so I'm gonna use 2015 as the example. The biggest driver of locomotive utilization and car velocity is train speed. With the year-over-year growth, our train speed has declined and affected both of these metrics. However, in comparison to 2015, again, even though volumes were still 6% lower than this year, we improved our velocity while matching both train speed and locomotive utilization. We did this through an aggressive approach to increasing train size, something that we will continue to focus on.

On a productivity front, both our yard and train productivity improved over both 2016 and 2015. Our plan to tackle train speed reduction is in place. It includes both innovative approaches as well as improvements that will be made through capacity and safety investments. Our focus on efficiency and reliability will never wane. With a longer-term plan to fundamentally change operations through technology, automation, and optimization, the introduction of new operational and service systems will provide the opportunity for our customers to grow their markets efficiently. On the safety front, we continue to build a greater understanding of risk awareness within our team. We are capitalizing on our strong relationship with our operating unions to ensure everyone genuinely looks out for each other. Our FRA accident ratio did increase from 1.57-1.61 on a year-over-year comparable.

While both those numbers are a continuous improvement over the last five-year run rates, our accident costs this quarter, well in line with previous year's run rates, were higher than in 2016. For injuries, we are slightly up over our ratio for last year. Comparing to the last five-year run rate, though, we continue to improve on the absolute number. However, productivity improvements that reduce human work hours have affected the ratio. To all of us, this slip is just not acceptable, and regardless of volume increase and mix of employee experience, we know that our most valuable asset is our people, and we will correct this. Overall, we're working very hard to improve our safety record and have a number of initiatives headed up by a newly developed and integrated team. So overall, I'm very pleased with the team's performance in the quarter.

With the volume growth, we definitely had challenging conditions to deliver these results. It's clear the team came through once again, and I am grateful for the opportunity to lead them. With that, over to you, JJ.

JJ Ruest (EVP and CMO)

Well, thank you, Mike, and great job on moving all this freight. Today, I will keep my comments to three high-level topics. I will start with a high-level description of how we achieved success in the last quarter, followed by last quarter major variance, and I will close with recent progress on our commercial agenda. So let's start with how we achieved success in the last quarter. First, we outperformed the economy. Our revenue was up CAD 487 million, or 17% above last year. Year-to-date, our revenue was up almost CAD 750 million, or 13% above last year, more precisely, CAD 729 million. We also outperformed the rail industry. CN's AAR carloads were up 14.5%, versus the industry average of 6.7% in Q2.

Year-to-date, our carloads were up 11.8% above last year, versus the industry average of 4.6%. Also very important to us is to achieve broad-based, diversified source of growth. And to that point, all of our business unit produce good growth this quarter. On top of that, three segment have had all-time record, company record, namely International Containers, Automotive Finished Vehicle, and Frac Sand for oil and gas drilling. Finally, we generated same-store price above rail inflation at 2.3% for the quarter and 2.5% for year-to-date. I will now highlight selected segments that produced the most variance. Frac Sand, as Mike mentioned, was up 175%. Total Canadian grain carloads were up 23%.

Container volume from Vancouver South Shore, Vanterm and Centerm Terminal were up a combined 135%. Potash carloads were up almost 20%. Automotive carloads were up 9%. It is worth noting, CN handle about 70% of all the finished vehicle sold in Canada. Coal carloads were down 3%, but revenue was up a solid 33% because of business mix. The Port of Montreal and Halifax volume, when combined, were up 10%. Our volume for natural gas liquid, plastic pellets, and condensates were down. The Canadian dollar and our fuel surcharge program versus last year were both positive tailwind to our reported revenues, respectively, CAD 85 million for FX, CAD 62 million for the fuel. Now, I will highlight recent progress on our commercial agenda.

The new customers that we onboarded earlier this year are delivering solid growth. The Port of Prince Rupert created an all-time high rail volume in June, a good omen for the upcoming three years. Sand Products, LLC of Blair, Wisconsin, opened a new frac sand mine on CN, and we expect another of our sand customers, Wisconsin Proppant Company of Ixonia, Wisconsin, to further increase production on CN as well. Crude volume bounced back from last year's Fort McMurray fire, but the last Eastern Canada refinery that was using crude by rail will stop doing so sometime in late August. Whirlpool announced they will build a regional distribution center in our Calgary logistics park, which further progress our co-location strategy with distribution centers and intermodal.

But our strategy also applies to grain, where we have a number of grain country elevators, either as new build or expansion of existing, elevators, to be done by Viterra, Cargill, GrainConnect, G3, P&H, Ilta. And the same co-location strategy also apply to export transload. We have Ray-Mont Logistics, who are building a major grain transfer facility in Rupert for this summer. CMA, the ocean shipping line, will start a new service on the East Coast at the Port of Saint John, New Brunswick, further building our three-coast strategic advantage. In the case of the Port of Saint John, our strategy focus is on ocean container, on coal supply chain business, and on bulk export of potash.

The new Duluth, Minnesota, container terminal is now in operation, and we are also finalizing plans to have a container terminal service in Regina by the 2018 grain crop. This is further advancing our overall strategy of increasing our geographic reach by adding new and more destinations. And last but not least, our technology business team, which is now fully staffed, is in full project development mode to digitize CN next generation of supply chain services and build a foundation of our future competitive edge. In conclusion, to wrap this up, we had a good, diversified quarter... with a number of good business units coming through with good results. The economic outlook for Q3 look constructive, and we're on track for the full year volume guidance. Ghislain, do you want to pick it up from here?

Ghislain Houle (EVP and CFO)

Thanks, JJ. Starting on page 11 of the presentation, I will summarize the key financial highlights of our solid second quarter performance. As JJ previously pointed out, revenues for the quarter were up 17% versus last year, at slightly over CAD 3.3 billion. Fuel lag on a year-over-year basis represented a revenue tailwind of CAD 20 million or CAD 0.02 of EPS, mostly driven by an unfavorable lag in the second quarter of 2016 for the same amount. Operating income was slightly under CAD 1.5 billion, up CAD 202 million or 16% versus last year. Our operating ratio came in at 55.1% or 60 basis points higher than last year. Fuel prices had no impact on the increase this quarter.

Net income stood at CAD 1.031 billion or 20% higher than last year, with reported diluted earnings per share of CAD 1.36. Adjusted EPS was up 21% to CAD 1.34 from a year earlier EPS of CAD 1.11, excluding the impact on deferred income tax expense from the enactment of changes in provincial income tax rates in both years. The impact of foreign currency was CAD 28 million favorable on net income, or CAD 0.04 of EPS in the quarter. Turning to expenses on page 12, as Mike previously pointed out, we continued to make progress in the quarter in terms of efficiency gains, including disciplined cost management initiatives, despite a significant increase in volumes. Our operating expenses were up 18% versus last year at just over CAD 1.8 billion, mostly driven by stronger volumes and higher incident costs.

Expressed on a constant currency basis, this represents a 16% increase. At this point, I will refer to the variances in constant currency. Labor and fringe benefit expenses were CAD 527 million, or 10% higher than last year, as increased wages and incentive compensation expenses were partly offset by higher capital credits. On a full year basis, we still expect pension expense to be roughly flat versus last year. Purchase services and materials expenses were CAD 432 million, or 12% higher than last year. This was mostly the result of higher outsourced services and repair and maintenance costs, mostly driven by higher volumes. Fuel expense stood at CAD 329 million, or 30% higher than last year. Higher volumes accounted for a CAD 37 million increase, and price was an unfavorable variance of CAD 27 million versus 2016.

Fuel productivity was about 1% improvement in the quarter versus last year. Depreciation stood at CAD 326 million, or 8% higher than last year, mostly as a result of net asset additions. Equipment rents were up 8% versus last year, driven by increased car hire, partly offset by lower lease expense. Casualty and other costs were CAD 117 million, which was CAD 42 million higher than last year, mostly driven by higher incident costs of CAD 21 million and an increase in environmental provision of CAD 7 million. For the balance of the year, we can expect about CAD 90 million-CAD 100 million per quarter for casualty and other. Moving to cash on page 13, we generated free cash flow of CAD 1,659 million through the end of June.

This is CAD 490 million higher than in 2016, and mostly the result of higher cash generated from operating activities, lower capital expenditures, and lower cash taxes. Finally, our 2017 financial outlook on page 14. We achieved solid volumes in the first half of the year, reflecting strong performance across most segments. We continue to see favorable economic conditions in North America, including a stronger than expected Canadian economy. In addition, consumer confidence remains positive, while a strong energy sector is driving shipments of frac sand and steel pipes. Crude volumes are strong, but this remains a spot business. However, we expect volume growth in the second half of the year to be more challenged, as comparables with 2016 will be more difficult, particularly in the fourth quarter.

We believe this environment should continue to translate into volume growth of approximately 10% in terms of RTMs for the full year versus 2016, with overall pricing remaining above inflation. We have recently experienced a strengthening of the Canadian dollar versus the U.S. dollar, and assuming the current spot rate of around CAD 0.80, this will create a headwind on earnings going forward. As a reference, CAD 0.01 appreciation in the Canadian dollar versus the U.S. dollar results in an annual headwind on net income of approximately CAD 30 million or CAD 0.04 of EPS. Despite the dollar headwind, we are reaffirming our guidance and continue to expect to deliver adjusted earnings per share in the range of CAD 4.95-CAD 5.10, versus 2016 adjusted diluted EPS of CAD 4.59.

In fact, should foreign exchange remain at CAD 0.80, we could finish at the upper range, at the upper end of our range. On the capital front, we remain committed to reinvesting in our business to support safety, service, and growth.

...In this regard, we continue to target a capital envelope of CAD 2.6 billion for the year and about 20% of revenues going forward. Furthermore, we continue to reward our shareholders with consistent dividend returns, and we are on track with our current share buyback program of approximately CAD 2 billion, having repurchased just over 14 million shares for CAD 1.3 billion since last October. In closing, we remain committed to our agenda and continue to manage the business to deliver sustainable value today and for the long term. On this note, back to you, Luc.

Luc Jobin (President and CEO)

All right, thank you, Ghislain. In closing, let me add a few words. Looking ahead, we hold a positive view of the economic environment, and we expect to have volume growth in the second half, although we will be facing some tougher comps versus last year. Our strategy of leveraging CN's superior supply chain approach to grow faster than the underlying markets continues to bear fruits, and JJ highlighted a number of opportunities for us on the way forward. Mike and our operating team are energized, and all hands are on deck to balance operational and service excellence. Our focus remains on delivering value for our customers and ultimately for our shareholders. In spite of a stronger Canadian dollar, Ghislain confirmed that we're also on track to deliver against our yearly outlook, both in terms of earnings and reinvesting in our franchise.

On that note, we're happy to now take your questions, and we'll turn the call back over to you, Patrick.

Operator (participant)

Thank you. Please press star one at this time, if you have a question. There will be a brief pause while the participants register for questions. Thank you for your patience. The first question is from Ravi Shanker from Morgan Stanley. Please go ahead.

Ravi Shanker (Managing Director)

Thanks, good evening, everyone. A couple of questions, if I can squeeze it in. One is on pricing. Clearly, this is an industry-wide issue, but and you guys saw sequential price deceleration like everybody else. But can you just elaborate a little bit more on the drivers of this? And, as inflation increases in the second half, what could be your sources of price gains?

JJ Ruest (EVP and CMO)

Hi, it's Ravi, it's JJ. So at 2.3%, I believe that we are in the range of our industry. We're also in the range of the first quarter. On the grain side, we do seasonal pricing, so we don't take the grain cap and spread over 12 months. We apply that price increase when the demand is strongest and take it away when the demand is least. But at 2.3%, I think we are meeting our objective of same store price. Above rail inflation, rail inflation is below that at this point. And I think-

Ravi Shanker (Managing Director)

And as it increases... Sorry, go ahead.

JJ Ruest (EVP and CMO)

I think they were forward. That's the range that we're in as an industry.

Ravi Shanker (Managing Director)

Great. Thank you.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

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

Fadi Chamoun (Equity Research Analyst)

Okay, thank you. Good evening, everyone. So, JJ, just a question on the crude by rail, which seems like it could be a significant opportunity for you guys going into 2018 and maybe even a little at the end of this year. Can you give us your thought on this, if you had any discussion with producer, what this opportunity might look like, and sort of potential timing of that ramp up?

JJ Ruest (EVP and CMO)

Yeah, I think, Fadi, I like one of your headlines from one of your report, where you say, "Crude by rail, unfortunately, interesting, but yet, not yet exciting." Meaning, there's not yet a capacity shortage of the pipeline capacity. So production is ramping up. Depending who you talk to, it may be later this year or early this year, but production may exceed pipeline capacity, at which time there would be a window for crude by rail to move product from Alberta to wherever the consumer within North America. But at this point, it's not part really of a base case, that we expect a lot of crude by rail pickup in 2017 anyway.

But if there is, now we do have the network and the ultimate power to do that, so we, we are in position to be able to do that. And if ever the Canadian grain crop is a little less than the average, you know, that crude by rail would be a nice way to fill up the second and third quarter of 2018. At this point, it's a wild card. It's... We have to wait for the pipeline industry to be, to be tight.

Operator (participant)

Thank you. The next question is from Walter Spracklin, from RBC. Please go ahead.

Walter Spracklin (Managing Director and Equity Research Analyst)

Thanks very much. Good afternoon, everyone. So I guess my I want to focus here on grain and the outlook here, and I know moisture levels are pretty low on the prairies right now. So my question is, how do you look at the your forecast versus a fairly significant comp from last year? How should we be modeling, you know, an average crop or the risk that it goes below average? And do you expect that to be aggravated by any share loss relative to a fairly strong, you know, share gain you had last year?

So could you, you know, talk whether you think you're gonna lose a little bit of share next year, temporarily, if anything, and what the impact downside could be if we don't get any rain in the prairies here in the near term?

JJ Ruest (EVP and CMO)

So if we take the usual pattern of the year, CJ, in the third quarter, what really matters is how really is the crop? Is it coming, is it harvest in early September, so we can move in September? Or is it coming in quite late, where it's two-thirds or too late of third quarter? When it gets to the fourth quarter, every year, Mike's team railroad very hard because we know the crop is super big or less than average. Everybody wants to sell grain in the fourth quarter, so we run flat out. Typically, the same thing in wintertime. So the size of the crop is really a second and third quarter 2018 question. And that's really, I think, it's too early to tell.

We will know by the time we have the third quarter result in, late to mid-October, we will know how big is that crop, and then we'll know the story for 2018. In term of share, I would advise the people not to bet against us. We're pretty competitive when it comes to the marketplace.

Luc Jobin (President and CEO)

Yeah, let's just say, Walter, that we don't plan on losing share, so, and the rest for us is all upside, and we're focused on growing the business. So, we'll see how, and we'll see how things unfold.

Walter Spracklin (Managing Director and Equity Research Analyst)

Great. Thank you very much.

Luc Jobin (President and CEO)

Thank you.

JJ Ruest (EVP and CMO)

Sure.

Operator (participant)

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

Tom Wadewitz (Senior Equity Research Analyst)

Yeah, good afternoon. Just wanted to see if you had, I guess we've heard from CSX, and they've talked about, you know, some people from, you know, another organization that knows about precision railroading and some operational talent has come over to them. It's not real clear what level or whether that's from, you know, directly from you or former CN people. But I just wanted to see if you could comment on whether there are concerns about, you know, any kind of operational managers leaving and, you know, whether that's something you've seen at this point. Thanks.

Mike Cory (EVP and COO)

Hey, Tom, it's Mike here. Yeah, look, we've lost a few frontline supervisors, so you know, really, the effect is small. And just so everybody's clear, my job, my team's job, is to continue to keep, teach, coach, develop people so that we can look down the bench and always have the right amount and the right type of people in line. And right now, I look down the bench, and I'm extremely comfortable. So it's, you know, it's a compliment for others to come and emulate our approach, and we'll continue to develop people and go forward, but no issue on our part.

Tom Wadewitz (Senior Equity Research Analyst)

Is there a way to kind of frame the magnitude of it? Like, you know, it doesn't sound like something you're concerned about, but is there a way to say out of, you know, how many people out of that level of, you know, is it two out of 30 people at that level, or is there any way to kind of gauge it?

Mike Cory (EVP and COO)

I guess I'd use the words, "not significant.

Tom Wadewitz (Senior Equity Research Analyst)

Just not significant. Okay.

Mike Cory (EVP and COO)

Yep.

Tom Wadewitz (Senior Equity Research Analyst)

Thank you. Appreciate it.

Mike Cory (EVP and COO)

Well, thanks, Tom.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Cherilyn Radbourne, from TD Securities. Please go ahead.

Cherilyn Radbourne (Managing Director)

Thanks very much, and good afternoon. Wanted to give JJ a bit of a break by asking Mike a question. Obviously, you know, continued strong performance in accommodating the volume growth that you've had. I think most of us on the call would have some familiarity with how mix can impact metrics like revenue per carload or revenue per RTM. I just wondered if you could speak in a bit more detail about how you look at those six key operating metrics and assess them internally in light of volume growth in mix to assess how well you've done.

Mike Cory (EVP and COO)

Okay, Cherilyn. You know, really, it's been a little bit difficult of a year in terms of trying to compare it to a previous, especially 2016. With the volume growth itself, you know, the key components here to what we look at, train speed, car velocity, locomotive productivity, locomotive utilization. Those things are gonna have an impact from that much of a volume growth. We've identified clearly areas that we've got to get closer in and diagnose the issue in terms of the train speed. We've identified some pinch points, but you know, really, we'll do the same thing we always do, that's use a an integrated team approach, use all the resources we have, and really look at the existing plan and infrastructure and go from there.

You can—you know, in terms of just pure productivity, our focus is on train load, on how we handle cars and costs to put them through yards, whether it be an intermodal yard or whether it be a switching yard. Those things never change, and that's something that's always right front and center of us. If that helps answer any questions you have.

Cherilyn Radbourne (Managing Director)

That's my one. Thank you.

Mike Cory (EVP and COO)

Yeah.

Luc Jobin (President and CEO)

Thank you, Cherilyn.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Scott Group from Wolfe Research. Please go ahead.

Scott Group (Managing Director and Senior Analyst)

Hey, thanks. Afternoon, everyone. So I don't, I don't know if this is for Luc or Ghislain. I just wanted to ask, you know, more broadly, kind of on, on the way the model is working. So, you know, it's the second quarter in a row where revenue growth outpaced operating income growth. And is there, in your mind, something unusual the past two quarters, just given either something on the cost side or just the magnitude of the revenue growth? Or is this how you... maybe we should think about the model going forward? And maybe more as we, you know, kind of look to the back half of the year when revenue and volume growth decelerate into tougher comps, should we still think about operating income growth growing slower than revenue growth?

Or do you think we should go back to maybe the normal way of thinking about rails, where you see some operating leverage and operating income growth exceeds revenue growth? I know a long question, but hopefully, you-

Luc Jobin (President and CEO)

Yeah. Scott, thanks for the question. It's Luc. Listen, it, you know, we don't think that there's any significant change. For, you know, it's really a question of mix... and how much business is coming on board. In addition to that, there are occasionally one-time items that, you know, can cloud a little bit the analysis. So, we still think that the historical model does work. From time to time, what will happen is, you're bringing on board a significant amount of volume, so in that sense, your incremental margin is not gonna be even, and progressive. So I think that's a little bit of what we've seen.

If you take a step back and look at the first half of the year, our incremental margin is probably sitting around 50% or something like that. You know, we look at the back half of the year. You know, Mike is in a good position to continue to improve on the operating metrics. You know, we feel pretty good that we can see you know, potentially a little bit more operational leverage kicking in. You know, the nature of the mix and the nature of what we're bringing on, a lot of it has been long-haul business, unit train, and in many cases, customer cars.

So that also will tend to create some noise in terms of, you know, if you're looking at the revenue yield versus the operating profit yield. But, you know, we feel comfortable that, you know, there is no fundamental change in the model and the way we look at the, you know, the balance of the year and the way forward.

Ghislain Houle (EVP and CFO)

And Scott, this is Ghislain, I would also say that, as in my remarks, that we had a little bit of a spike up on a year-over-year basis on incident costs, by about CAD 21 million. So again, that is reflected in the numbers. But to emphasize Chip's point, I think the model is working.

Luc Jobin (President and CEO)

Thanks very much, Scott.

Scott Group (Managing Director and Senior Analyst)

All right. Thank you, guys.

Ghislain Houle (EVP and CFO)

Thank you.

Operator (participant)

Thank you. The next question is from Turan Quettawala from Scotiabank. Please go ahead.

Luc Jobin (President and CEO)

Go ahead, Turan.

Turan Quettawala (Director of Equity Research)

Sorry, I was on mute. Good afternoon. So I guess my question was on the fuel lag here. I was just wondering if you could talk about whether that started to benefit you at all at the end of the quarter, and maybe is that something that could benefit you in Q3? And is it gonna be enough, potentially at current prices to offset some of the FX impact?

Ghislain Houle (EVP and CFO)

Yeah, Turan, this is Ghislain. So as I mentioned in my remarks, fuel lag helped us by CAD 20 million, or CAD 0.02 in the second quarter. In the third quarter, very, very small, I would say. We're looking possibly at a positive lag this year of about CAD 10 million. So and there was nothing last year, so on a year-over-year basis, you could be talking about CAD 0.01 in the third quarter.

Turan Quettawala (Director of Equity Research)

Great. Thank you very much.

Ghislain Houle (EVP and CFO)

Thank you.

Operator (participant)

Thank you. The next question is from Ken Hoexter from Bank of America Merrill Lynch. Please go ahead.

Ken Hoexter (Managing Director)

Great, good afternoon. Can you just maybe JJ, talk a little bit more about intermodal? I think you mentioned a new Regina container program for grain. Are you focusing converting bulk traffic over and away from the highway? Or, and maybe talk a little bit about the benefits of the tightening U.S. truck market, if you're seeing that on growth opportunities yet.

JJ Ruest (EVP and CMO)

Okay. So the initiative in Regina has to do with balancing the expansion we have at Prince Rupert and at Belle Plaine to offer the shipping line a revenue that makes sense for them. We need to offer them that's not only just a good destination, but also some revenue on the way back. And in southern Saskatchewan, there's this big growth on the specialty crop. Most of them are sold overseas. A lot of them are sold in containers. So two products we're gonna be offering in order to do that. One is this summer, Ray-Mont Logistics will have his transfer facility completed by the month of August in Rupert. He will be able to receive full unit train or specialty crop from anywhere in the prairies of the U.S., to loading container at the port itself.

And then, by the summer of 2018, we will be able also to receive loaded container or specialty crop to be loaded in Regina, which is much closer to where the product is being grown. Regarding the question on trucking, I guess it's almost like a capacity and price, more a price question. We're not really, really seeing yet the tightening of the marketplace, including the highway, at least on what we do, which is mostly repeat contract business, not spot business, that's actually driving price here on domestic intermodal. So at this point, that's, I guess it's something to come, but not there at this point. Did that help, Ken?

Ken Hoexter (Managing Director)

Yeah, it does. Thank you very much, JJ.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Steve Hansen from Raymond James. Please go ahead.

Steve Hansen (Managing Director)

Yeah, good afternoon, guys. My question's on coal. Specifically, we've seen a pretty significant mix shift of late that I think you described in your remarks. I'm just curious about your outlook here for the met side in particular, and some of the traffic that's coming out of the northeast part of British Columbia, and what we should expect into the balance of the year and next year. Thanks.

JJ Ruest (EVP and CMO)

Okay. Thank you, Steve. So, the Canadian coal that we move to the West Coast is mostly a met coal, some terminal coal, but also met coal. We also do quite a bit of petroleum coke from northern Alberta, that's which is also in our coal results. That coke is mixed in our coal result. So those business, whether it's pet coke from Fort McMurray or Canadian coal from Canadian coal mine in Beise, Alberta, I would describe them as steady. So now we are at a cruising pace, and the sequential volume will probably stay as is. When it comes to U.S. coal, it's one of our question mark for the fourth quarter.

So why we're not sure yet how much growth we will get in fourth quarter in total, it's related to U.S. coal, it's related to U.S. grain and how that will pan out. Because the U.S. crop doesn't look fantastic, and the crop in South America looks great. They have a lot of product, and we don't know if you know, we were gonna be competing to move corn and soybeans to the Gulf by unit train, or will a lot of that will end up moving by barges on the Mississippi, since the Mississippi barge rates are quite low.

Steve Hansen (Managing Director)

Very good. Thanks.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Brandon Oglenski from Barclays. Please go ahead.

Brandon Oglenski (Director and Senior Equity Analyst)

Hey, good afternoon, everyone. Thanks for getting me on. I guess I wanted to revisit Scott's question, maybe in a different way. When we were at the Analyst Day, last month, you guys focused a lot on the intermodal opportunity. So I guess, you know, just thinking into next year, if you're gonna see mix, more from intermodal outgrowing the rest of the business, you know, could this be a potential source of, you know, margin headwind, as we would think about, especially with the Canadian dollar strengthening? And could 2018 maybe be a continuation of the themes we've seen in 2017?

Luc Jobin (President and CEO)

Yeah. Thanks, thanks for the question, Brandon. It's Luc. Listen, again, we don't really see that as, as, taking shape. We've always said that, you know, the margin on the intermodal business is, you know, on the average, for the book of business. So in that sense, we don't see a significant shift. And again, we've got the structure to actually take on the volume, so we don't foresee a significant change.

Brandon Oglenski (Director and Senior Equity Analyst)

Okay. Thank you.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from David Vernon from Bernstein. Please go ahead.

David Vernon (Managing Director and Senior Analyst)

Hey, good afternoon, guys, and, thanks for taking the question. Luc, I wanted to kind of hit a little bit on the same topic. It does look to me like the incrementals, if you strip out the favorable benefit and pension and even a little bit of the currency, you're running closer to 20%, and yet your volume growth is running at the high end that we've seen over the last 10 years. What is it that's taking away the normal, volume-driven leverage we would expect to see? Again, if you're getting priced above inflation, this kind of volume-driven leverage, I would have just sort of expected a better operating income result.

Luc Jobin (President and CEO)

Yeah, David, let me take a step back and kind of walk you through this a little bit, because this is a question that's come up a couple of times, and I think we wanna make sure people get a clear sense of what's going on. A lot of the growth that we've had has actually been, you know, very much long-haul business, you know, around coal, around,

JJ Ruest (EVP and CMO)

Potash.

Luc Jobin (President and CEO)

Potash-

JJ Ruest (EVP and CMO)

Frac sand.

Luc Jobin (President and CEO)

Frac sand, and so on and so forth. So it is, you know, it's, it's, it's very good growth, but it's long haul. It's also, as I mentioned earlier, customer equipment. So when you look at, you know, the revenue, what you're gonna get is, you're gonna get a lower revenue yield. So that's not a factor of, you know, weak pricing. That is a factor of, you know, the revenue we charge for the hook-and-haul business, and it, and a lot of it is unit train as well. So that is, you know, we have to disassociate that from the cost structure, because the cost structure for moving that business is in fact lower.

You don't have to pay for, you know, the car supply and, you know, we do have a very good margin on that business. So in effect, if you look at what's happening in terms of the operating ratio and leave aside some of the noise which you rightly referred to, which may happen from one quarter to the next. In some cases, you've got FX, you've got fuel, and you've got some of the, you know, casualty costs that can distort a little bit your quarterly numbers. But on the whole, as I mentioned earlier, you look at the first half of the year, and our incremental OR is 50%. So, you know, we are not seeing a shift away from profitability.

What happens is the mix and the nature of the business we're picking up is leading to very strong GTMs and RTMs. You know, the revenue profile is different. So I think that is something that certainly was present in the first half of the year. Probably we're not gonna see as much of that in the second half, but there will be some. So you kinda have to work your way through the nature and the mix of business, and you have to look at, you know, other metrics, not just your revenue yield, to assess the quality of what we're bringing on board in terms of growth, as well as our efficiency numbers.

So, you know, when Mike looked at some of the, you know, operational productivity numbers, again, they're solid when you compare against, similar, work levels, and volume levels back to 2015. So, you know, when you look at all of the other measures, you should gain some comfort, that there isn't something going on here, where we're bringing on what I would describe as low-quality, growth. That's not the case. And, you know, I mean, again, the team is very much focused and very, you know, we wanna bring in good business on board, but we also, as I said, it can be lumpy. So in this quarter, we picked up a lot of business, and so did we in the first quarter.

And the team, you know, the first mission for the team is bring it on, you know, make sure that the levels of service are good, and then we kind of look at grinding it out. So, you know, we are constantly looking for opportunities where we can not only, you know, lower the cost of servicing the business, but as a matter of fact, how can we enhance the service levels? So you will see that taking place, and that is why I think, you know, longer term, you know, we don't feel that we have to turn business away. We have confidence that we can do it. We don't, you know, we don't. And JJ showed you what the, you know, the pricing levels are.

So we're very thoughtful in pricing the business, in attracting good business, and then, you know, working it through to maintain the profitability levels that have made us, you know, the leading Class One in the space. So all that to say, we feel pretty good about where we are, and you know, we'll continue to crank out these numbers on the way forward. And probably you'll see a little bit less of this pattern, but it will, you know, there will still be some certainly in the second half of the year.

David Vernon (Managing Director and Senior Analyst)

Thank you. Maybe just as a quick follow-up to that, as you think about grinding up, is that a question of rewriting the contracts, or is it a question of maybe just getting it more ingrained in the operation and catching up a little bit on the productivity side?

Luc Jobin (President and CEO)

Yeah, it's not rewriting the contract, trust me. It's you know it's the innovation. It's pushing the envelope. I mean, this is what Mike and his team excel at doing day in and day out. So it really is you know looking at you know where and how can we improve as I said on the two key dimensions that we always focus on, efficiency and service. And we the team's mission and the team's mandate is you know not to achieve one at the expense of the other. So that's what you have to look at, and you know keep keep your eyes on the team. You know that's what they do best. Thank you, David.

David Vernon (Managing Director and Senior Analyst)

All right, thanks.

Operator (participant)

Thank you. The next question is from Chris Wetherbee, from Citigroup. Please go ahead.

Chris Wetherbee (Senior Research Analyst)

Hey, thanks. Good afternoon. Wanted to talk a little bit about the volume cadence in the back half of the year. So I think you had a couple of comments about some of the things that could be variables, particularly to the fourth quarter. But when you look at the RTM guide and your progress so far, I guess I'm just curious, you know, what is the risk to the fourth quarter in terms of actually seeing negative RTMs? And maybe what are some of those major variables, I'm guessing grain, and I think you mentioned U.S. coal could also be part of it, but I just want to get a sense, maybe with some more detail about what some of those moving parts could be in 4Q.

JJ Ruest (EVP and CMO)

So, Chris, it's JJ. When we get to fourth quarter, one of the thing we're unsure at this point, one is U.S. coal, U.S. grain, the crop, but also whether it move on the long-haul railroad or short-haul to the river. Sulfur is also a question mark for us, either liquid or going to the U.S. or dry going to the coast. So it's really typically us on the bulk side. And potash, you know, Uralkali and Potash have both settled their contract with the Chinese, which means now our contract will be settled for all other countries. But we don't know whether or not we will have the same record potash move than we did last year, the fourth quarter, which was very strong.

And by the way, that's an example of where Mike has rewritten how we do business. When we move these potash trains from Saskatchewan to Saint John, we now move them 205 cars. Nobody moved train of 205 cars in North America. So obviously, your cost per unit is down. That's how we can compete on a lower cent per RTM and make money as part of that. So the fourth quarter question mark is more about the bulk side and whether or not we will have, you know, be below last year or surprise ourselves and be as good or maybe better than last year. We feel more comfortable-

Chris Wetherbee (Senior Research Analyst)

But-

JJ Ruest (EVP and CMO)

about the rest of the economy.

Chris Wetherbee (Senior Research Analyst)

But as it stands, you get positive RTMs in your model for the fourth quarter?

JJ Ruest (EVP and CMO)

So yes, some. And then the places in the model we have negative RTM is both related and the uncertainty about the commodity, of which, I talked about.

Luc Jobin (President and CEO)

Clearly, Chris, I mean, it is tapering down, there's no question about that. But we don't – as JJ pointed out, we don't see negative RTM growth, but there is a tightening up that will take place in the fourth quarter. So far, the third quarter is looking good.

JJ Ruest (EVP and CMO)

Yeah, first three weeks, pretty good.

Luc Jobin (President and CEO)

So we'll have to walk it home.

Chris Wetherbee (Senior Research Analyst)

All right, great. Thank you.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Konark Gupta from Macquarie Capital Markets. Please go ahead.

Konark Gupta (Equity Research Analyst)

Thank you, and good afternoon. It's just a question on metals and minerals. I guess frac sand, iron ore, and steel have driven the segment so far this year. So where do you see trends in those commodities in the second half in 2018? Is there any stickiness, basically, in the existing frac sand business, if growth and drilling activity slows down more materially? Thank you.

JJ Ruest (EVP and CMO)

Yes, it's JJ. So yes, there is stickiness in the frac sand business. We foresee as frac sand sequentially stay at the rate where it is right now till eventually we lap. But, you know, we had a very strong second quarter in frac sand, and if it sequentially maintain that rate, it's very positive. When you look at the CN, M&M, Metals and Minerals category—You have frac sand into that, you have steel, you have mineral, you also have iron ore. But the one that really is driving this category year-to-date is the frac sand, and we believe the frac sand will hold.

Luc Jobin (President and CEO)

Thank you, Konark.

Operator (participant)

Thank you. The next question is from Benoit Poirier, from Desjardins Capital Markets. Please go ahead.

Benoit Poirier (VP)

Yeah, good afternoon, gentlemen. JJ, a lot of color about the currency impact on translation and also on the EPS. But when you talk to customers, I, I was wondering if you could point out the strength of the Canadian dollar, whether you see some potential impact on some commodities, and whether it makes the Canadian ports losing some of their competitive advantage. So talking about grain, coal, forest product, whether it could impact some volume in the longer term.

JJ Ruest (EVP and CMO)

Yes, thank you, Benoit. It's still early on. It's what? A couple of cents, maybe up to CAD 0.05, and I don't know if the Canadian dollar will go up from this point or stay the way it is. No, I don't think we don't have customers at this point, where those CAD 0.04-CAD 0.05, you know, is gonna have a material impact on their sales in the United States or sales abroad. But frankly, at CAD 0.70-CAD 0.72 Canadian, that was quite, quite weak, too. So you one would not think the Canadian economy has to rely on such a weak dollar. I think at this point, I mean, this is not a huge change, a couple of cents from the point of view of our customers and their production costs.

Benoit Poirier (VP)

Okay, thanks for the color.

JJ Ruest (EVP and CMO)

Thank you, Benoit.

Operator (participant)

Thank you. The next question is from Brian Ossenbeck from JPMorgan. Please go ahead.

Brian Ossenbeck (Senior Analyst)

Hey, good afternoon. Thanks for taking my question. So just going back to the Investor Day, you said the cost of Positive Train Control would increase, and it wouldn't be a small number. So Mike mentioned hiring some people for technology and PTC. Where does the OpEx and CapEx stand related to that system right now, and where do you expect that to settle out when everything's online, you know, call it 2018, the first half, subdivision's done in 2020, when everything's wrapped up?

JJ Ruest (EVP and CMO)

Yeah. Thanks, Brian. Yeah, when you look at PTC this year, I think what we're looking at is possibly about CAD 120 million. A third of that would be depreciation. And in terms of the future years, I think we're not gonna provide guidance on the future years. I think we're very focused, and the team is very focused on delivering, and we're in the thick of it, and we're advancing, so it's good. And we'll see, and frankly, we need to deliver PTC first before we know, once we're there, how much it's gonna cost us to support it. But we know this year that it'll be CAD 120 million, and a third of it is depreciation.

Brian Ossenbeck (Senior Analyst)

Okay. Thanks for the color.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Justin Long, from Stephens. Please go ahead.

Justin Long (Managing Director)

Thanks, and good evening. I know it may be a little bit early for this question, but I was wondering if you had any thoughts or expectations on this year's peak season, just given some of your port capacity expansion projects. I thought you might have an early read, so I'm curious what you're expecting and what's baked into your guidance for the back half of the year?

JJ Ruest (EVP and CMO)

Justin, it's JJ. I think for us, at this, for this year, especially this year, the fact that Rupert's capacity should be available to all of us by late August and Delta for sometime in the fall, might be more relevant than the fall peak itself. Because now we have the ability to access all the capacity, and the question will be whether or not CN, DP World, and the GCT collectively, we've been able to sell some of that as early as August, September, October, November.

So we are planning for significant growth in the overseas intermodal related to, yeah, fall peak, but more about the capacity available to us and all the pre-marketing that we did about the service that we collectively offer, including, you know, the service that we have in the South Shore, Vancouver, which really has huge, be a huge help to us in the last six months.

Justin Long (Managing Director)

Okay, great. But maybe to just follow up, if you stripped out the capacity additions that you have planned, does it feel like the underlying demand environment as it relates to peak, will improve this year relative to last year?

JJ Ruest (EVP and CMO)

I wouldn't say so. No, I don't think the peak this year will be of a different trend of bigger than last year. But the Canadian economy right now is doing fairly good. So I mean, the consumption by the Canadian consumers and the U.S. Midwest and U.S. Mid-America consumers seems to be solid and good, and obviously, we benefit from that as well.

Justin Long (Managing Director)

Okay, great. Appreciate that.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Allison Landry, from Credit Suisse. Please go ahead.

Allison Landry (Senior Equity Research Analyst)

Good afternoon, thanks. Thinking about the guidance for the 10% RTM growth, you know, it's basically implying a full year number, which is, you know, I guess, slightly above the peak that you saw in 2014. So, are you at the point where you're, you know, basically really needing to think about ramping up resources? And, is it fair to say that you're, you know, potentially approaching capacity levels?

... you know, mix I know is a factor, but you know, any way you could help us think through this would be helpful. Thanks.

Ghislain Houle (EVP and CFO)

Yeah, Allison, this is Ghislain. From a resource standpoint, we do, and we are hiring. I mean, if you look at the end of Q4, 2016 versus the end of Q1, 2017, we added about 300 people, and our labor productivity in terms of million GTMs per employee was up 14%. When you look at the end of Q2 versus the end of Q1, we've added another 540 people, and again, our employee productivity was up 14%. So we are adding people. We said we were going to do that.

And we have to do that a little bit in advance because there is a lead time to train these folks, whether it's, you know, our crews or whether it's engineering or mechanical folks. So we're trying to be ahead of the game. But obviously, as you can see from these statistics, we are not adding one for one, so we are absorbing. And then I'll ask Mike to settle in on capacity. Mike and I and JJ are connected very close at the hip. We're looking at volumes coming. We're always working together to see potential pinch points, where they are. And we wanna be ahead of the game. We wanna be investing before it happens, but we don't wanna do that too early either.

So we are currently investing to support our intermodal business. We are investing to support our growth in frac sand. From a capacity standpoint, we will continue to look at this and do that next year. So I think that, you know, it's a lot of volume coming at us, so we're pleased about the work that we've done. We're pleased about the fact that we've been able to absorb and we'll continue to absorb some of that volume, and we're pleased about the fact that, you know, we're trying to stay ahead of the game in terms of our investment.

Mike Cory (EVP and COO)

Mm-hmm. And I can't add a whole lot since Ghislain said most, but I'll refer to what Luc was talking about. You know, Allison, we really, we clearly diagnose whatever the issue may be that's creating what we might see to be a pinch point. And before we spend, we look internally, whether it's infrastructure we already have, whether it's some innovative way to approach it, but that's been our template for a long time, and that'll continue. But to Ghislain's point, we know the areas that we've seen extreme growth. We know the areas that we've seen train speed drop to a degree.

We've definitely come together as a group, and we've identified a lot of things we're going to do, and we'll see where that takes us, and we'll do what we have to do in order to service the customer the way they expect and need, and the way we need to keep the cost down.

Luc Jobin (President and CEO)

Allison, just to, you know, put icing on the cake here, you're getting all, you know, three for one. You know, I would say, it's Luc, I would say that, you know, what we constantly do is we triage and we prioritize where we see the most leverage and the most opportunities for deploying the capital. So that is always... You know, what we've talked about is within the scope of our capital envelope.

Mike Cory (EVP and COO)

Yeah.

Luc Jobin (President and CEO)

And what we do is we prioritize, depending on where and how we see the opportunity. So you shouldn't expect a significant shift in the profile of our CapEx over time. It should be in line with what we've described at the Investor Day. Thanks for your question, Allison.

Allison Landry (Senior Equity Research Analyst)

All right, thank you.

Luc Jobin (President and CEO)

Yeah.

Operator (participant)

Thank you. The next question is from David Tyerman from Cormark Securities. Please go ahead.

David Tyerman (Analyst)

Yeah, so just following up on the comments on hiring. So should we expect hiring to continue at 300-500 people additional, or does it slow down quite a bit as the volume growth slows down?

Ghislain Houle (EVP and CFO)

Listen, I think I'm not gonna give you, David, a specific number. What we're gonna do is continue to. We will hire. We're looking at what's ahead of us, but we'll not hire one for one. So that's the key, and we're gonna continue to absorb some of that volume with the service and the operations that we have, so.

David Tyerman (Analyst)

Okay, thank you.

Luc Jobin (President and CEO)

Thanks, David. All right, well, thank you for the questions. Obviously, we're very pleased, and we're very proud of our second quarter results. I think they continue to support, you know, what we have been doing for several years in terms of advancing our strategy and gaining traction in the marketplace. And, you know, we continue to see future growth, you know, ahead of what the base markets, you know, can bring to us. We've got a lot of good initiatives going on. You know, our offering in the marketplace is resonating with customers. So, you know, we feel good about our ability to attract, retain, and work through efficiently, you know, the business that we're bringing on board.

So, a good quarter, a very good quarter, actually, when you look at these numbers, and I think the year is shaping very well. And again, we're, you know, restating our guidance, and we're staying in spite of some of the changes in currencies and other little headwinds, we're staying the course. So, you know, we're looking forward to bringing you up to date when we have our third quarter call. And in the meantime, thank you for joining in, and you know, we'll see you later. Thank you.

Mike Cory (EVP and COO)

Thank you. Have a great summer.

Luc Jobin (President and CEO)

Thank you, Patrick.

Operator (participant)

You're welcome. The conference has now ended. Please disconnect your lines at this time, and thank you for your participation.