Canadian National Railway Company - Q3 2013

Transcript

Operator (participant)

Welcome to the CN third quarter 2013 financial results conference call. I would now like to turn the meeting over to Janet, Vice President, Investor Relations. Ladies and gentlemen, Ms. Drysdale.

Janet Drysdale (VP, Investor Relations)

Thank you, Marcus. Good afternoon, everyone, and thank you for joining us. I would like to remind you of the comments already made regarding forward-looking statements. With me today is Claude Mongeau, our President and Chief Executive Officer, Luc Jobin, our Executive Vice President and Chief Financial Officer, Jim Vena, our Executive Vice President and Chief Operating Officer, and JJ Ruest, our Executive Vice President and Chief Marketing Officer. In order to be fair to all participants, I would ask you to please limit yourselves to one question. It's now my pleasure to turn the call over to CN's President and Chief Executive Officer, Mr. Claude Mongeau.

Claude Mongeau (President and CEO)

Thank you, Janet, and thank you to all who are joining on this call. We are pleased to report very good third quarter results. Clearly, our transformation journey is continuing, and the key elements of our agenda are gaining momentum. If you look at it during the quarter, we had a slow start in June and July from a revenue standpoint, but all revenues rebounded nicely in September, and more important than that, we were able, throughout the quarter, to continue to outpace base market conditions. So that helped us deliver solid top-line growth. JJ will give you the key numbers in a minute. We were able to accommodate that growth at very low incremental cost. If you look at Jim's report on his page, where the key operating metrics are all laid out, it's basically all green.

So this is solid operating performance, but also very good service outcomes for our customers. We are balancing operational and service excellence the way we are aiming for. Perhaps the most important number on this page is at the bottom of the page. During the quarter, we had a very solid safety record. Our FRA accident ratio was 1.31, which is roughly 43% better than last year for the third quarter. This means that we have only 1.3 accidents for every 1 million train mi that we move of goods across the country. Obviously, we do have accidents from time to time. We had a very serious one this weekend with fire involving propane cars in Alberta.

I think our response, which was led by Jim, who just came back from the site, was comprehensive and we are focused, as we speak, on returning service levels to our customers. Delivering safety and responsibility is a foundation for CN, and we are continuing to focus on improving our record in this regard. So very solid third quarter result. Jim will start by the operating, you know, overview, and then, you know, JJ and Luc will wrap it up with the revenue and financial performance. Jim?

Jim Vena (Executive VP and COO)

Okay, thank you very much, Claude. So how do we, how do we, judge success and did the team perform? Our goal is to balance operational excellence with solid customer service and have an unwavering commitment to safety. And as Claude just mentioned, we just had an incident in Western Canada, in Alberta, that we had to deal with. And the processes and all the people that we had involved, I think we had to deal with it. We've dealt with it. We've moved on. We're gonna learn what we can. We're gonna make sure we understand what happened there and do everything we can to improve our safety record even further than what we've done over the last few years. So let's take a look at the operating metrics here in some detail.

As Claude mentioned, the operating metrics, if we take a look at what we're able to perform in yard productivity and terminal dwell, and how we're working through the terminals, I think good metrics, 13% in yard productivity, meaning we handled more cars with the same number of hours and people. The terminal dwell, better. We've been able to put them through at a rate about 5% better, which is in the right direction. Our train productivity, we've been able to add more tons on the trains per mile, so that means that the increase in business that JJ and the marketing team has been able to deliver has allowed us to put the trains to bigger size.

And also, we're working always hard to optimize the number of trains we have and using supply chain views to make sure that we're running them when we're supposed to be running them, and make sure we run them efficiently when we operate. If we take a look at the metrics as far as locomotive utilization, again, a 4% improvement from where we were last year and the year before, so it ties into the better handling of the train. Train velocity, a little bit better, not quite where I'd like to have it, but better than before.

Of course, my favorite, anybody who's been listening to me since I got the job, the metric that tells me whether we've got the right systems in place and we're headed in the right direction, is car velocity, and we ran at about, 5% better, 223 mi per day. I'm very proud of the team. I think, I've got a lot of talent that works directly for me, but even more important, we've got talent right through the whole team, and the culture is headed in the right direction. I think we're close. I think there's more to, more to give, but at the end of the day, it was on four of these six metrics, we had, record performance. So good job by my, by my whole team, right from, top to bottom and bottom to top. Excellent.

But it's a balancing, it's truly a balancing act of what we try to do. It is. You could get even better operation, operating numbers if you didn't worry about service, but at the end of the day, you don't get customers if you don't have service. So for us, it's the balancing of the two, and we have been pushing hard as part of our cultural shift to make sure that we drive the decision-making down to the front line. We want our employees at the front line to be capable to, to make the right decisions and at the right level so that we get even more push and more value out of our operating metrics. With the network and the capital that we put in, and, and I'm sure that that Luc's gonna talk about it here in a minute, it's very important to us.

It allows us to be able to move the traffic in an efficient manner. We committed to putting $100 million more in the key Edmonton to Winnipeg corridor and have it completed by the end of the year, and it's nice to report that we are on track, and I'd expect in the next four or five weeks to be on there. I guess the nice challenge, JJ, before, I mean, JJ, before I pass it on to you, is we got a record grain crop, and it'll be interesting to see how well the scope, our supply chain view of how we move products from origin to destination, and how we look at it more than just on the railroad, how well we do. So it'll be interesting to see what happens.

With that, JJ, I'll pass it over to you.

JJ Ruest (Executive VP and CMO)

Well, thank you, Jim. Building up on what Jim just mentioned in terms of the efficiencies and very strong asset utilization, the revenue in the last quarter increased 8%, which is a new quarterly record, as it should be. The team is on track to use service to grow the business, that is, service as defined by customers, while making decision every quarter and every month. Volume and mix produced 2.5% of the overall third quarter growth. The exchange rate added 2.5%, fuel surcharge, another 1%, and same stores price on same stores sales, including coal, was 3.0%. CN is focused on better product, not cheaper price.

Product which produce a lower supply chain cost for the customer, and product that becomes a competitive edge for our customers and help them win in their own marketplace. I will now do a quick rundown of the quarter, as usual, on the FX adjusted basis. I will start with petroleum and chemical, which revenue was up 13% on a flat carload. Chemical revenue was up 9%, with solid growth from basic chemical and plastic pellets, in line with the positive auto and construction sector. Crude revenue also experienced very strong growth. The runway for the third quarter was about 70,000 carloads annualized, and about 80% of our business mix currently is what we call heavier crude. Metals and minerals revenue was up 7%, led by frac sand revenue, which grew a very solid 60%.

We continue to see production ramp up in Wisconsin on our Barron Sub, namely the Superior Silica Sand 2.4 million ton plant, which started up last year, and the CSP plant, which is currently under construction. At least two new plants should be built on our Wisconsin division in 2014. Forest product revenue was up 5%. Our lumber and panel to the US was up 10% and 17%, respectively. Our Asian lumber exports were also up 23%. CN will largely dominate for years to come, the lumber and panel originating space in Canada. Pulp and paper commodities were flat to last year. Our coal franchise was relatively stable in the quarter. Revenue decreased only 3%, and remember, our coal makes up only 7% of the CN total book of business.

Both the met coal and pet coke business were positive in the last quarter. Thermal coal was negative. We have secured a new thermal contract, which will help us shore up our thermal coal result in early 2014. Grain and fertilizer revenue was down 5%. However, as Jim mentioned, we experienced in September a positive sharp transition in the grain after a very weak July and August. The grain export supply chain is now running at maximum capacity, and the fertilizer revenue were flat on currently a very confused world product market. To be noted, the pricing for the regulated Canadian grain cap will transition from the +9.5% that it was last year to a -1.8% as of August 1st, 2013. This will create a year-over-year headwind comparable for grain same store pricing.

Automotive revenue was up 4%. The consumer vehicle sales in the cities on our network drove our business, namely imports from Vancouver were better. We estimate CN currently moves about 50% of the new finished vehicles sold in Canada. That is before the addition of Chrysler in mid-2014. Intermodal revenue kept its relentless pace of growth. Revenue was up 12%, units were up 8%. The international segment grew 13%, domestic grew about 10%, which is a nice balance. Our recent investment in destination terminals are producing good results. I especially like our progress in the markets of Detroit, Saskatoon, Joliet, and Calgary. The way we redefine supply chain transportation time has changed the Canadian port business.

As a result, as you know, in 2013, we attracted the business of APL of Singapore, MOL of Hong Kong, UASC of Dubai, and therefore, our third quarter revenue for the Port of Vancouver was up about 30%. On domestic, we benefited from new supply chain product, namely coal supply chain, some new customers like Target Canada and Hudson's Bay, as well as a double-digit growth in the industrial sector. Our carload and regional sales force gives us more intermodal boots on the ground than anybody else in the country when it comes to the industrial sector. Now moving to the outlook. The fourth quarter carload and RTM will grow. They will grow sequentially from the third quarter, and they will grow from versus last year.

Our volume in the fourth quarter will be driven by housing starts, automotive sales, a better grain crop in both Canada and the U.S., ethane and natural gas feedstock, which are more affordable than ever for the petrochemical customers, energy consumable like proppant and crude. As is usually the case, in our well-balanced and diversified portfolio, some pockets, though, will be weaker, namely some of the coal, potash, sulfur, and petcoke. The Western Canadian crop production is estimated to be in excess of 60 million tons, and our Canadian grain supply chain will run at full capacity during the fourth quarter. Also worth noting, our underutilized network between Chicago and Halifax will gradually benefit from new and profitable business, namely crude to Eastern Canadian refineries or ACL container as of January in Port of Montreal and later next summer, Chrysler in Ontario.

In intermodal, we already have the foundations laid out for 2014. We estimate our Port of Montreal rail share will move from 40%-50% during the course of the year, and our port of rail business in Vancouver will also do very strong. In conclusion, the team is on track for growing the business based on service. We're using our overall service as a major competitive edge, and we are doing so at very attractive margin. As Claude mentioned earlier, our OR operating ratio was at 59.8, and we invite you to join us in our December Investor Day, where we'll go into more detail of our go-forward business plan. On that, I'll pass it on to Luc, our Chief Financial Officer.

Luc Jobin (Executive VP and CFO)

All right. Thanks very much, JJ. Starting on page 14 of the presentation, let me walk you through the key financial highlights of our third quarter's performance. Our revenues, as JJ pointed out, are up some $200 million or 8% to nearly $2.7 billion. Operating income was just shy of $1.1 billion, up nearly $100 million or 10% versus last year, as we saw solid productivity, safety, and service levels, which were coupled with cost management in the quarter to complement revenue growth. This is an all-time record for CN in terms of quarterly operating income. Our operating ratio is 59.8% in the quarter, which represents an improvement of 80 basis points versus last year.

Other income stands at $5 million in this quarter, the result of lower activity levels, as expected, compared with $18 million in 2012. On a full-year basis in 2013, I would expect other income to finish in the range of $10 million on an adjusted basis. Our reported net income for the third quarter is $705 million, up 6%. The favorable impact of the currency change was $14 million on net income, and the reported diluted EPS reached $1.67, up 10% versus last year. In the third quarter, however, we recorded a $19 million increase in deferred income tax expense, resulting from the enactment of a higher provincial corporate income tax rate in the province of B.C.

This brought our effective tax rate to 29.5% in the third quarter. Excluding the impact of this one-time deferred income tax expense, the adjusted diluted EPS is $1.72, which represents a 13% increase over last year's third quarter. Turning to page 15, operating expenses were $1.6 billion, up 7% versus last year or 4% on a constant currency basis. At this point, I'll refer to the changes in constant currency. First, labor and fringe benefit costs were $521 million, an increase of $37 million or 8% versus last year. This was the result of three elements. First, an increase in overall wage cost of 4%, mostly the product of wage inflation for 3 points and 1 point for increase in average headcount in the quarter.

The second element is higher pension and health benefit expenses for 6 percentage points of the variance. The third and last element, partly offsetting these cost increases, was a 2 percentage point favorable variance relating to more capital work being performed in the third quarter this year versus last. Looking ahead to the fourth quarter, keep in mind that we expect some headwinds. Some of it will come from stock-based compensation, given where the stock price is currently at. Also, last year, I'll remind you that we had the reversal of a former executive's compensation benefits. So these elements alone could represent some $30 million of unfavorable variance in the fourth quarter. Turning to purchase services and material expenses, they were $318 million, up 3%.

This was due to higher volume, resulting in increased intermodal trucking expenses, combined with higher repairs and maintenance expenses, but partly offset by lower project-related contracted services. The fuel expense stood at $390 million, an increase of 1%. Higher volume represents an increase of 3.5 percentage points in the quarter, while improved productivity constituted an offset for 1.5 percentage point, and price was also favorable by 1 percentage point. Depreciation is $11 million higher than last year, or 5%, due to a combination of asset additions as well as Canadian and U.S. depreciation studies. Some of these depreciation studies will be completed through the fourth quarter and some into 2014.

Given the timing for completion, I now estimate that our depreciation expense will increase by approximately $40 million, but the impact will be about $20 million through 2013, and we'll see an incremental $20 million or so in 2014. Turning to page 16, let's talk a little bit about free cash flow. We generated nearly $2.5 billion of cash from operating activities. This was $114 million, or 5%, higher than in 2012, mostly as a result of improved working capital. The main element contributing to this year-on-year improvement in working capital was lower pension contributions this year for approximately $365 million.

This was partly offset by higher income tax payments, as cash taxes to date were $516 million more than last year. Our 2013 year-to-date, over $1.1 billion of cash was used in investing activities. That's $327 million more than last year, and the different results mainly from lower proceeds from non-core asset sales for $259 million and $64 million of higher capital expenditures this year. We're still on target for a $2 billion capital expense budget for the year. And so after deducting dividends, $778 million of free cash was generated for the first nine months of the year. Meanwhile, our balance sheet remains strong, with debt and leverage ratios well within our guidelines.

We have completed the stock buyback program of $1.4 billion announced last October. Consistent with our strong shareholder return agenda, our voters approve a new stock buyback program allowing the repurchase of up to 15 million shares over the next 12 months, and I've set aside about the same budget as in previous years, about $1.4 billion to get this accomplished. We also announced a 2-for-1 stock split and the payment of our quarterly cash dividends. Finally, on page 17, our financial outlook. With the benefit of our third quarter performance, and assuming a stable economic environment through the fourth quarter, we expect to finish 2013 on a strong note.

As such, we're therefore reaffirming our annual guidance, which aims for high single-digit EPS growth in 2013, over 2012's adjusted diluted EPS of $5.61. We also continue to target free cash flow in the range of $800 million-$900 million. On that note, I'll turn it back over to you, Claude.

Claude Mongeau (President and CEO)

Well, thank you, Luc and team. Clearly, the solid Q3 results show that we are gaining momentum. You know, we're entering Q4 with, you know, the hope to finish the year strongly, as Luc just explained. Our short-term focus with the residents of Gainford now safely back at home, our focus is on recovering a fluid network. We have a lot of work to do to catch up in terms of traffic for the benefit of our customers. We are also, this week, focusing on concluding, hopefully, a labor agreement with our conductors. The discussions are ongoing, and I'm hopeful that we will be able to reach a win-win agreement in the next few days. As we look out, strengthening our supply chain mindset and our capabilities, effectively embedding our strategic agenda is what we are focused on.

There's a lot coming our way in terms of initiatives. We are getting good response from our customer base, and stakeholders understand that we are a true backbone to the economy. At the end of the day, it's all about creating solid value for our customers and our shareholders, and that's our commitment to all of you on this call. With this, I will turn it over to the operator for Q&A.

Operator (participant)

Thank you. We will now take questions from the telephone lines. If you have a question and you are using a speakerphone, please lift your handset before making your selection. If you have a question, please press star one on your telephone keypad, and if at any time you wish to cancel your question, please press the pound, the pound sign. Please press star one at this time if you have a question, and we'll take a brief pause for the participant to queue up for the questions. We have our first question from Brandon Oglenski from Barclays. Please go ahead. Your line is now open.

Brandon Oglenski (Director, Senior Equity Analyst)

Yeah, good afternoon, everyone. Congrats on the good quarter.

Claude Mongeau (President and CEO)

Thank you, Brandon.

Brandon Oglenski (Director, Senior Equity Analyst)

I wanted to ask about the contract wins that you guys have announced here, and I know you said that this was all based on service, not a price decision by the customers. But can you talk about some of those service aspects and whether or not taking on all this business, you'll be able to maintain that really good progress on the OR that we saw, you know, this year and this quarter?

Claude Mongeau (President and CEO)

Well, you know, that's our game plan, is to outpace base market and to be able to accommodate growth on a go-forward basis. If you look at our volumes through the third quarter, and particularly in September, we are really ramping up. The last, you know, few weeks of September and the first few weeks of October, we are, you know, actually delivering record volumes. More than 1.2 billion GTMs per day is what we've been able to do. So we're geared up. We have a lot of investments to add to our resiliency. Jim and I were actually visiting our Prairie North Line and our new investments on the main line between Edmonton and Saskatoon.

We really like what we have seen there, and, and we are gearing up all of our resources, our assets, our people, our network to be able to handle the business that our customers have trusted us with. So that's the game plan, and we have every, every commitment or every, all of our efforts are designed to actually deliver flawlessly.

Brandon Oglenski (Director, Senior Equity Analyst)

Thank you.

Operator (participant)

Thank you. Our following question comes from Scott Group from Wolfe Research. Please go ahead. Your line is now open.

Scott Group (Managing Director and Senior Analyst)

Hey, thanks. Afternoon, guys.

Claude Mongeau (President and CEO)

Hi, Scott.

Scott Group (Managing Director and Senior Analyst)

So, Claude, you, you mentioned a couple of times how, how things feel like they're accelerating, momentum is building. You got, call it 13% earnings growth with a few percentage point headwind from, from pension. As you look out, not to fourth quarter, but over the next year or so, is there any reason you, you think in, in a stable economy with the market share gains you're getting, why you can't continue to get kind of 15%+ underlying earnings growth?

Claude Mongeau (President and CEO)

Well, I think we're gonna be sitting down with every one of you who are gonna visit us, December, early December. I think it's on the 10th or the 11th. So for our Investor Day, we'll give you we'll give you more specific guidance at that point into next year. But, you know, clearly, we have good momentum, so we're pleased with how things are going, and we are certainly aiming to deliver solid, you know, like, continued solid growth in EPS and solid free cash flow. It's a bit early to guide into next year, but we like our results in Q3, and we're geared up to finish Q4 on a strong note.

Operator (participant)

Thank you. Our following question comes from Walter Spracklin, from RBC Capital Markets. Please go ahead. Your line is now open.

Walter Spracklin (Managing Director and Equity Research Analyst)

Thank you very much. Good afternoon, everyone.

Claude Mongeau (President and CEO)

Afternoon.

Walter Spracklin (Managing Director and Equity Research Analyst)

Just on, I guess this one is for Jim. Obviously, you've had some pretty impressive statistics here on an operating side through the summer here in the third quarter. Looking back at last year when we did have winter, you know, obviously, winter is gonna come again, and let's assume for the moment it is a difficult one like it was last year. Can you talk to us a little bit about what you've done in the intervening months or period that has better prepared you for the winter period, especially given a lot of this new volume that JJ has done a good job of bringing over on your network, you know, a lot more volume, potentially, a tough winter.

How are you preparing for that?

Jim Vena (Executive VP and COO)

Well, Walter, I hope you're wrong. I've, I've been looking forward, and I've gone to charm school and everything else, and I am hoping that we get one of those nice, easy Canadian winters. But if we don't, let's say we get a winter like we had last year. There is. It's multifaceted. You've got to look at the locomotives. We've gone through the locomotives top to bottom. We have looked at their resiliency to make sure that they perform well in the cold weather, and we don't have some of the issues. We've learned some things on some of the different fleet that we have. We are getting new locomotives in the fourth quarter delivered, which will help us make sure that we get through the winter better.

We have looked at people to make sure that we've got a few extra people in place so that we're ready to go. On top of that, we have trained, 800 conductors, and we have a number of locomotive engineers that are qualified and ready to run if we need them in Canada to help us out. I don't think we'll get to that point, but if we do, we have some backstop on it. We're very careful on, on, on the cars and how we're gonna manage the railroad, and I think one of the biggest things will be, is how fast we react to, the network and the fluidity of the network. And it's a truly a science and something that, I think we've got a good plan going forward.

The last part is, we've invested capital, not only $100 million to help us between Winnipeg and Edmonton, and when Claude and I went on the inspection trip, and we went from Edmonton over the Prairie North Line to see the siding growth, the track structure, making sure that the welds are completed, so we have nice, safe track on the Prairie North Line to give us that option, plus on the mainline piece, the double track pieces that we put in. So it's a long list. I guess I could go on for an hour, and then Claude and everybody else would be wondering why I took all the time. But Walter, we're as ready as we can be.

Walter Spracklin (Managing Director and Equity Research Analyst)

Sounds like it. Okay, thanks very much. Congrats on a good quarter.

Jim Vena (Executive VP and COO)

Thank you, Walter.

Claude Mongeau (President and CEO)

Thank you.

Operator (participant)

Thank you. Our following question comes from Tom Wadewitz from JPMorgan. Please go ahead. Your line is now open.

Tom Wadewitz (Senior Equity Research Analyst)

Good afternoon, and you know, congratulations on the good numbers and strong results. I had a question for you. Again, I don't know if it's JJ or Claude or maybe both, but how do you think about the impact to the competitive dynamic as you've taken some share? Do you think of it as being, you know, there was some opportunity, you take some business, and maybe you see stability and less movement of share in 2014 or 2015? It just seems that there's, you know, a finite number of big intermodal contracts, and you know, if you push too hard, then you might hurt the pricing dynamic, or, you know, maybe it's fair to think there's a stabilization in share.

I just wonder if you had any thoughts on, you know, how you thought that, share and pricing dynamic might play looking forward?

Claude Mongeau (President and CEO)

Mm-hmm. Then, Tom, we don't price to gain market share. We provide service to attract customers if they believe we can help them win in the marketplace. We are pleased that some believe we can actually help them win in the marketplace. But at the end of the day, there's a market out there. We have a, you know, very competent competitor across the street, and, you know, we don't take anything for granted. We just hustle every day. We have a good supply chain product. We have an end-to-end approach to how we actually deliver value, and we're getting very, very good response in the marketplace. The more we do that, the more opportunities for having more business over time. But it's not at all about price, it's about servicing our customers. JJ, you wanna add to that?

JJ Ruest (Executive VP and CMO)

Yes. I think in both cases, it was definitely long sales process. Sales process over, you know, in one case, over a year, in the other case, probably over three years. And in both cases, you know, explaining and selling what we can do, how we do it, and how we can add value to these two accounts in a way that was fitting their own need for, in one case, supply chain, and the other one, you know, people like us, when transportation and they have a product to sell, which they to try to make it better. So a lot of effort on explaining the product and the reach and the service that we have. And in the end, I guess, we quote prices like everybody else, but price was not the reason for them to make such a switch.

Tom Wadewitz (Senior Equity Research Analyst)

So, you know, I guess assuming that it is service driven and maybe there's a piece of price or maybe not, you think the key component about maybe less movement in share looking forward, is that reasonable or not necessarily?

Claude Mongeau (President and CEO)

I would say, Tom, like, it's not assuming, it is absolutely service. So you know, the recent customer that are coming to our way are solid, profitable customers, and we are servicing them, and that's why they came over. And we are not—I mean, we are gonna go in the marketplace following our customers, not chasing customers through price. That's not our approach. It's not good for the industry, and ultimately, it doesn't create a good marriage. As JJ said, some of these customer dialogues have been going on for several years, and they chose to come over because we have a good service, not because we have a low price.

Tom Wadewitz (Senior Equity Research Analyst)

Okay, thanks for the time. Appreciate it.

Operator (participant)

Thank you. Our following question is from Cherilyn Radbourne from TD Securities. Please go ahead. Your line is now open.

Cherilyn Radbourne (Managing Director, Equity Research)

Thanks very much. Good afternoon. So the record Canadian grain crop is certainly a welcome development in the context of a slow growth economy. I wonder if you could just speak to what, if any, tweaks you're making to your service plan to maximize capacity, and whether you think your supply chain focus can be a competitive advantage in this context.

Claude Mongeau (President and CEO)

Yeah. I'll let Jim add to this, but it's definitely a big challenge. There's a record crop out there, and we really gotta step up to put all of the pieces of the supply chain in sync to be able to get our spotting well above 5,000 every week. So obviously, this week we're gonna have a little challenge with the derailment over the weekend, but the last couple of weeks, Jim, we've been doing 5,300, 5,400 spots a week, and we gotta keep it going through the November-December period to meet customer demand. But what's your recipe?

Jim Vena (Executive VP and COO)

I think, if we focus from end to end, then we gotta make sure that we've got the right plan at origin, working closely with the elevator, Cherilyn, and so that they're ready for us. We're not wasting car time, and we're not wasting load time and locomotive time. I think that's real important. And at the West Coast and in Thunder Bay and even up in Churchill, we're moving some grain up to Churchill. We make sure that we partner, and we understand what the flow of the ships are coming in, what they can take out, and make sure that that all works together so that we can react and go to the right place, whether it's the Prince Rupert, the Vancouver, North Shore, South Shore, and the Thunder Bay.

So if we get that all in the mix, we should be able to maintain that, the number well over 5,000. You can see I didn't go as high as Claude. Over 5,000 from now moving forward.

Cherilyn Radbourne (Managing Director, Equity Research)

All right, thanks. That's my one.

Jim Vena (Executive VP and COO)

Thank you.

Operator (participant)

Thank you. Our following question comes from Chris Wetherbee, from Citi. Please go ahead. Your line is now open.

Chris Wetherbee (Senior Research Analyst)

Thanks. Good afternoon, guys. Maybe just touching on the pricing environment. When you look into 2014, you've seen some of the share move around a little bit. Just kind of curious to get your sense on the sustainability of sort of this 3% run rate that you guys have been able to consistently put up. Just wanna get a sense of, you know, how the pricing environment feels right now and, and maybe what to think about for next year.

Claude Mongeau (President and CEO)

I don't know if we're gonna get into guidance on next year, but the current run rate is a run rate that we think, you know, there's a number of puts and takes in our current run rate, obviously with different businesses of different segment. And I talked about the Canadian grain cap, for example, but we're comfortable the Canadian run rate is something that we can sustain, probably not necessarily sustain with the same mix of business, but every year we've got, you know, some, some strength and some weaknesses, and that's how we, we make up the average total.

Our goal is definitely to price above inflation in line with the value of our service. I think, you know, the fourth quarter is a good indication of what we believe we are able to do in the next, you know, year or so, for sure.

Chris Wetherbee (Senior Research Analyst)

Mm-hmm. Great. Thank you.

Operator (participant)

Thank you. Our following question is from Jacob Bout from CIBC. Please go ahead. Your line is now open.

Jacob Bout (Managing Director, Senior Equity Analyst)

Good afternoon. Just maybe you can give us your thoughts about the outlook for crude by rail, given some of the recent derailments, and specifically thinking about from a regulatory perspective what's being discussed there, and also from an insurance perspective?

Claude Mongeau (President and CEO)

Yeah. Let me, JJ can fill in with some of the customers that are coming online, but let me restate what I said at the beginning. We have an unwavering commitment to operating a safe railroad. It's true of all the dangerous commodities that we move. To be able to have so few accidents in any given year with so much volume is quite remarkable. We move in excess of 1 billion tons of commodities every year to the benefit of the economy on both sides of the border. We have about 10% of that volume, which is dangerous goods, and we have a handful of accidents every month. Two to three would be our average.

It's difficult to get better than that, but we are committed to continue to improve, to make sure that we have as few incidents as we can, and that when we do have incidents, we are reacting to them with a comprehensive response, owning up to it like we did this weekend. So that's our strategy, and I think that, you know, when you go beyond the short-term impact, because it is disrupting the lives of the people of Gainford over the weekend, there are a lot of people that need to be reassured. At the end of the day, the facts are clear. We move more than 99.997% of dangerous goods to market without incidents, and we have to keep getting better.

And if we do, I believe we are a viable alternative to move all the energy project products, including crude. And as JJ will tell you, we move more heavy crude than we move light crude, and we believe this is there to stay with us as long as we continue to operate a safe railroad, which we are committed to do. JJ, you wanna add to this in terms of some of the things that are online?

JJ Ruest (Executive VP and CMO)

Yeah, we, as I said in my comment, our runway for crude is about 70,000 carload annualized, which is basically sort of the same sequential run rate we had in the Q2. But our RTMs are up because we're we moved last quarter same number of cars, more or less, but we moved them more miles, and that's why the revenue on crude was up. With the increased infrastructure in Alberta, which is where the heavy crude or more heavier type of crude is, this is why our movement is getting more toward the heavier crude, that in the case of CN, over 80%. And we should see sequentially increase in the fourth quarter versus third quarter, probably in the case of the fourth quarter, not just RTM, but also carload.

As the infrastructure is laid down more and more in Alberta, we will also see 2014 showing growth in carload and RTM and revenue. And then we'll, you know, without getting into the specific of how much, but it is still a growing story from a number of point of view, and our customers are all investing heavily in infrastructure as well.

Claude Mongeau (President and CEO)

Well, the challenge is on us, Jacob. If we continue to do a good job at moving these products safely, we believe we will continue to grow in this market.

Operator (participant)

Thank you. Our following question comes from William Greene, from Morgan Stanley. Please go ahead. Your line is now open.

William Greene (Managing Director)

Hi, good afternoon. Thanks for taking the question. Luc, can you just offer a little bit of color about what the trend is for the pension expense? I assume it'll be coming down next year, but maybe you can kind of help us think a little bit about how that would change, what the magnitude of the changes if this were year-end now.

Luc Jobin (Executive VP and CFO)

Yeah, I mean, a good question. Of course, this all gonna depend on where the discount rates will settle down at the end of the year. But if we were to look at where things are right now, indeed, we would have an improvement over 2013. This year, the pension headwind, as I mentioned earlier, is about $100 million to our pension expense. So, next year, I would hope that we're gonna see, you know, things probably flat to 2013, and potentially there could be also a slight improvement.

We're monitoring that, and I think there's probably a little bit of positive news, but we also are looking at what the Canadian Institute of Actuaries is doing with respect to the mortality tables. They will be implementing new tables, which unfortunately point to people living longer.

Claude Mongeau (President and CEO)

Why, why do you say unfortunately?

Luc Jobin (Executive VP and CFO)

Well, uh-

Claude Mongeau (President and CEO)

I think it's fortunate that we live longer.

Luc Jobin (Executive VP and CFO)

Yeah, from my vantage point, that's a, that's a bit of a problem, Claude. And so, so that will probably offset a little bit of what otherwise would have been a, you know, more, a more favorable situation. But I'm still, you know, optimistic that we'll be, you know, at, at, at least neutral to slightly positive on the pension expense.

William Greene (Managing Director)

Thank you.

Operator (participant)

Thank you. Our following question comes from Benoit Poirier from Desjardins Securities. Please go ahead. Your line is now open.

Benoit Poirier (Managing Director and Senior Equity Research Analyst)

Yes, thank you very much, and congratulations for the quarter. Just with respect to Prince Rupert, you've been experiencing a slowdown back in Q2, but could you please give us an update related to the quarter, and also discuss about the upcoming opportunities, including the potential opportunities with the Northern Gateway alternative and maybe Canpotex?

JJ Ruest (Executive VP and CMO)

Okay. So starting with intermodal, the business over Rupert has been year-over-year softer, and I think we're slightly negative. The two shipping line that we deal with in Rupert have taken pricing action different than some people who are doing business with us in Vancouver. And some of that business has moved from one shipping line to another, partly explaining why our revenue in Vancouver are up 30%. So it is what it is, you know, business move from shipping line to shipping line. And in the case of Rupert, the two, which are players in Rupert, have actually maybe not done as well in the last six months than those in Vancouver. Regarding Canpotex for potash, there's really nothing new. It's a major capital program.

The world market for potash, I would say, have looked better, you know, in the past, and I'm not too sure that, you know, there is in the cards of a major announcement in Rupert for a terminal at this point. I think the market for potash probably needs to sort itself out first.... And, I think you, what was the third part of your-

Claude Mongeau (President and CEO)

I think in the meantime, we're running very hard on grain. I think last week we were close to 1,500 cars unloaded in Prince Rupert. That's a key advantage we have. Very good cycles, and the three owners there are really committed to have strong volumes towards Prince Rupert to make sure that we create car capacity in this period of high demand. And our coal business is holding well. There's a lot of investments that have been made by RTI. The supply chain has never been more efficient. We just need the price of coal to come back up a little bit and volumes to get a bit more growth. And we have a lot of upside, I think, over time in coal for Prince Rupert.

JJ Ruest (Executive VP and CMO)

Yeah. No, on the coal, definitely, there's lots of capacity there. And when the market come back, and those markets do come back, it's a question of when, there'd be lots of capacity, even more capacity at RTI at that time to handle the coal and the pet coke.

Benoit Poirier (Managing Director and Senior Equity Research Analyst)

Okay, very good color. Any opportunity to rail oil sands crude to a B.C. port?

JJ Ruest (Executive VP and CMO)

There's no project, there's no infrastructure on the Canadian West Coast to receive crude by rail. There is no project proponent. There's really no support. I don't think it's, you know, any kind of a near-term type of potential.

Benoit Poirier (Managing Director and Senior Equity Research Analyst)

Okay. Thanks again for the time.

JJ Ruest (Executive VP and CMO)

Thank you.

Claude Mongeau (President and CEO)

Thank you.

Operator (participant)

Our following question comes from Ken Hoexter from Merrill Lynch. Please go ahead. Your line is now open.

Ken Hoexter (Analyst)

Great. Good afternoon. I guess the prior management really maybe wasn't as focused on client relationships. And, Claude, you've made a big focus on reconnecting with many customers. Do you think this is an impact on recent business wins in terms of the cost-cutting pace going on at your competitor? And are you seeing customers make some of the moves there? Just trying to understand some of the recent intermodal shifts and the potential for the additional pace on customer change. And I understand that you focus more on getting stuff from the highway, but I guess maybe the recent intermodal wins were a real eye-opener in terms of the pace we're seeing the switching there.

Claude Mongeau (President and CEO)

I mean, good question, Ken. I-- Let me put it to you this way: We have an absolutely customer-centric agenda. We want to become a true supply chain enabler, and our mantra is to help our customer win in the marketplace, and there's good reason for that. We want to be able to outpace base market conditions year in, year out. We wanna win market share against trucks with innovation, like our new selling One CN approach, our new cold reefer products, our new initiatives to create Intermodal Flex. That is helping on the one hand, our customers deal with issues, particularly in winter, but also help us gain market share at the margin versus trucks. We wanna gain market share against all railroads, not just our principal competitor in CP.

At CP, we wanna gain market share to the extent we can offer a good service and energy products against pipelines. And if we do that, and if we innovate and we add value to our customers to help them win in the marketplace, that's what we need to do to actually outpace base market and grow faster than what the economy would give us. That's what we've done for the last four years. That's what we plan to do again in 2014 and for many, many years to come. That's the strategy, and we're sticking to it.

Ken Hoexter (Analyst)

So, Claude, if I could just maybe just reconfirm what you had said earlier. In terms of winning the most recent intermodal contract, you said it's still extremely profitable business. So I guess, is that our interpretation, that you're not using price to win these contracts? Or, that maybe even the price that everybody was gonna charge was still an incremental step up, so it would have been still profitable business no matter who won it?

Claude Mongeau (President and CEO)

That's what I answered Tom. And those are, you know, very good customers. They're profitable accounts, and we are-- they fit very well in our portfolio, and they came over to us because of our service, not because of our price.

JJ Ruest (Executive VP and CMO)

Yeah, and service is just to maybe help put some color on what we define as service, we spend a lot of time understanding what a service means to somebody who's in a shipping line. And when they go out there and sell to either an automotive assembly plant or retailer, they sell a service from the time the box arrive at the port to the time the box is released in a major city. So having a rail service from terminal to terminal is not good enough. That's not what they sell. What they sell is from the time the box arrive at the port, the clock starts, and the clock stops when the box is released at the terminal, the destination where they need it. So the total transportation time includes more than just CN, obviously.

Ken Hoexter (Analyst)

It doesn't hurt if we can move the cars fast, right?

JJ Ruest (Executive VP and CMO)

Definitely.

Claude Mongeau (President and CEO)

That's right. That's your contribution, Jim. And also to add to what JJ is saying, that you know, in a world of larger ships, the having more destination reach is a huge asset. They need to fill those larger vessels or ships in order to get their economics to work. They need more destination. They need good transit time to promote asset efficiency, and they need match back. They need to be able to load as many boxes as possible on the return movement, and that's exactly what our strategy is designed to provide: more destination, more faster transit time, and significant opportunity through partnership to have higher match back, better you know, better overall economics for the customers.

Ken Hoexter (Analyst)

Excellent insight. Appreciate it.

Claude Mongeau (President and CEO)

Thank you.

Operator (participant)

Thank you. Our following question comes from Fadi Chamoun from BMO Capital Markets. Please go ahead. Your line is now open.

Fadi Chamoun (Equity Research Analyst)

Hi, good evening. Back on the intermodal side, and looking at it from the international side, I mean, we have seen, for the past few years, I guess, some conversion from U.S. to Canada and, and sort of, containers that would have gone through the U.S. ports, going through Canadian ports, and we see it in the Canadian port market share. My question is, what is the typical end market to this cargo that you're converting, sort of bringing into. And, and how big of a like, how big is this market that you can tap into?

JJ Ruest (Executive VP and CMO)

You're talking the U.S. market, Fadi?

Fadi Chamoun (Equity Research Analyst)

Yes.

JJ Ruest (Executive VP and CMO)

Yeah. So obviously, it has to be in a geographic area that we can actually serve, so you're talking U.S., Midwest, or connecting with Eastern U.S. railroad. And it probably is something that has a little time sensitive to it, meaning that it may not be the type of product that could go on a slower boat, all water, to the U.S. East Coast and then being trucked in, or product that will be transshipped more than, you know, one or two times. So it's, it's something that the, the ultimate customer would like to have a, this long rail bridge to, U.S. Midwest or Detroit or Ohio. So typically, auto part, fit in, in that category. That's kind of higher value, you know, type of supply chain. Things also has to do with, seasonality in the retail business.

In a retail business, when you have a product on the shelf in November and it's seasonal, you have a good price for it. If it comes in three weeks late, you'll have to sell at a discount, and now you're eating your shirt. So the product we have tends to be the product that has this sort of dimension where service in terms of consistency and not so much speed, because speed, people can figure out the speed unless you have a real slow service. But consistency and some element of speed is important to them, including the speed through the port. Because having a fast train from Vancouver to Chicago does not mean your container is on that train.

If your container is at the port for three days, sometimes four, sometimes one, sometimes six, a fast train to Chicago does not really meet the need of the assembly plant. And that's one of the key part of our service on the import side, is playing in team with the terminal operator and the shipping line, because that's what they're trying to have for the ultimate customer. So in terms of the size, I think we're still growing, and in order to do that, we've had to to get into new geographic pocket, like Joliet, Illinois, like Indianapolis, and we're also doing and growing still in places like Detroit and Memphis.

Fadi Chamoun (Equity Research Analyst)

Okay, thank you.

JJ Ruest (Executive VP and CMO)

Thank you, Fadi.

Operator (participant)

Thank you. Our following question is from Jason Seidl from Cowen. Please go ahead, your line is now open.

Jason Seidl (Managing Director)

Hey, guys, evening here. When I look at your book of business as it goes into 2014, what percent do you have under contracts in terms of stuff that's competitive with, say, CP or other rails, and what percent is gonna be coming up for renewal?

JJ Ruest (Executive VP and CMO)

There's no change in substantial change in how much business we offer renewal for the coming year versus past years. We're booking business in terms of contract versus tariff, short term versus long-term contract is no different between 2014. And we, like every year, I think we, we manage renewal and risk going forward in the same fashion, so there's no difference going forward.

Jason Seidl (Managing Director)

And real quickly, on a follow-up, to piggyback on a question that was asked before, have you guys seen any changes in terms of your insurance for handling any hazardous materials?

JJ Ruest (Executive VP and CMO)

No, we haven't actually. I mean, we have a very strong safety record. As I said earlier, our third quarter performance, for instance, was close to a record performance in terms of our accidents. I think, and I'm hopeful, that by the time we finish the year, we may be, if not the leader in terms of safety, you know, one of the top railroad. We have more detection technology deployed. We have a very, you know, structured response. And at the end of the day, the insurers look at facts in setting your premiums. So there's always, you know, up or down from a year to year, but our conversations in terms of renewals into next years are not indicating any major increases.

It's more the normal ongoing, depending on demand and supply in the insurance market.

Jason Seidl (Managing Director)

Guys, thanks for your time as always, and I'll keep my fingers crossed for you on the safety record.

JJ Ruest (Executive VP and CMO)

Thank you so much.

Jason Seidl (Managing Director)

Thank you.

JJ Ruest (Executive VP and CMO)

Thank you.

Operator (participant)

Thank you. Our following question is from Steve Hansen, from Raymond James. Please go ahead, your line is now open.

Steve Hansen (Managing Director and Equity Analyst)

Oh, yes, thank you, and good afternoon. Just as a follow-up on the grain pricing outlook, I'm hoping you can help us understand a bit better how we should think about the 1.8% price revision from the CTA, in the context of your broader portfolio, both regulated and non-regulated grains, and how the severe strains on the system that we're likely to see here in the next months might impact your decision to implement that decision throughout the course of the grain crop year?

Claude Mongeau (President and CEO)

Then I think, I mean, JJ, you can be more precise, but at the end of the day, all of the regulated grain is subject to that, you know, revenue cap, which is adjusted down this year based on the formula for inflation. So our grain business is less than 10%. Our regulated grain business is in the range of 7%-8% of our overall, 6% of our overall book of business. So, indeed, to the extent that's down a little bit, that will impact the overall price. But we said earlier that we're comfortable that our agenda of pricing above inflation, and certainly Q4, we've already have the new pricing in place. And we will see, fairly soon how it plays in the mix.

But we're very comfortable with that 3%-3.5% range for pricing.

Steve Hansen (Managing Director and Equity Analyst)

Yeah.

Claude Mongeau (President and CEO)

On a go-forward basis.

See, last year at the what the grain cap was providing last year, Canadian grain at about 6% of our book of business was helpful to bring the average up, where this year, at -1.8%, obviously, it will be a bit of a drag, and that's what it is.

Steve Hansen (Managing Director and Equity Analyst)

Okay, thank you. But just to clarify, in terms of the, your total book of grain business, which portion is subject to, what percentage is subject to the 1.8%, and which is non-regulated?

Claude Mongeau (President and CEO)

Only the Canadian grain, and that adds up to

Janet Drysdale (VP, Investor Relations)

Yeah, I can walk you through the numbers, Steve, after the call. We can, we can get into the detail.

Claude Mongeau (President and CEO)

Yeah, but it's definitely less than 6%, but in that range of 4%-6%, yeah, of the book of business.

Steve Hansen (Managing Director and Equity Analyst)

Okay, thank you.

Operator (participant)

Thank you. Our following question is from Matt Troy, from Susquehanna. Please go ahead. Your line is now open.

Matt Troy (Director)

Yeah, thanks. I just wanted to ask a question about intermodal margins. I know you don't speak directly to what they are, but your results certainly fly in the face of conventional wisdom, i.e., that intermodal growth comes at the expense of margins, and long-term, this might be a problem. Given your record margins this quarter, just curious, if you could just put into directional perspective, intermodal margins, you know, directionally improved versus three years ago, and might in three to five years time, that'd be something that could look more like the corporate average or even surpass your corporate average margins. Because, again, it seems to fly in the face of results, excuse me, conventional wisdom, that this is a sub-margin kind of heavy business.

Claude Mongeau (President and CEO)

Well, Matt, I think we try to lead the way in this regard, and we've said consistently that our intermodal business is actually quite close to our average profitability margin. It is a little bit less than the overall book of business in terms of margin, but not significantly. And so as we grow the business in intermodal, we like the margin. Of course, you know, your ability to accommodate incremental business, you always have a little bit of the leverage in terms of, you know, putting in more on the train, lengthening trains, et cetera. But at the end of the day, the overall book of intermodal is very close to our average corporate profitability, and we like it that way. And we have a very specific profit margin target to maintain that.

For example, revenue per train, not only going east, but going back out. We call that balance. Also, how many, how many container, revenue container we have per train, and different things that really, in the end, are way beyond just, you know, the price of, of each transaction is. Because the way we run these trains, how they balance, how they balance, whether they run long, whether they run with a lot of double stack, all these things add up to whether you run a fairly profitable or very profitable intermodal business. So actually, an area where supply chain is not just service, and it's not just growth, it's also efficiency. Our terminal partners are actually helping us—Yeah... you know, increase our slot utilization. The, I mean, the last couple of weeks, I was looking at things, you know, pretty good demand in the, in Vancouver.

Our slot utilization was close to 94% coming out of the Vancouver terminals. It's close to 99% in Prince Rupert. So they're really helping us get efficiency through higher slot utilization. And of course, the more you have your trains full, the less time the containers spend in the terminal, and that's also helping dwell, which is good for service. And the more growth, the more ability to leverage. So it's a little bit like the high-grade sausage, you know, like them fresh and keep them coming. Density balance is our key.

Matt Troy (Director)

All right. Thank you.

Claude Mongeau (President and CEO)

Thank you, Matt.

Operator (participant)

Thank you. Our following question is from Keith Schoonmaker, from Morningstar. Please go ahead. Your line is now open.

Keith Schoonmaker (Director of Industrials Equity Research)

Thanks. You called out nearing completion of the $100 million investment in track in Edmonton, Winnipeg, and I think Jim mentioned new locomotives coming out still this year. But as we think a little bit longer term, and I'm sure we'll hear more in the upcoming meeting, but can you give an idea of your thinking on the level of CapEx? Will it remain around 18% or 19% of revenue? And what types of projects do you expect to be most impactful, even over, say, the next three to five years?

Luc Jobin (Executive VP and CFO)

Yeah, I mean, I would say at this point that we're still very much, Keith, focusing on the 18%-20% range. What we do, and Jim and I, and the team have been reviewing, you know, what we see out there as being opportunities, whether to accelerate the growth of the business, so investing on more of the marketing side, or looking at infrastructure in terms of what can help us achieve more velocity, more sustainability in terms of performance. Claude mentioned as well, you know, safety is a big preoccupation of ours, so we are also looking at where and how can we improve that aspect of our infrastructure. So, you know, I don't expect major surprises.

I think we'll review, certainly, you know, the whole situation and, you know, coming out of next winter. We feel pretty good about the infrastructure that we've put down in the Winnipeg to Edmonton corridor, and we're constantly monitoring where and how the volume's coming onto the network. So, probably not a whole lot of difference, and, you know, a lot of interest on our part in securing locomotive power ahead of the, you know, ahead of the changes on the EPA side. So that, we'll see more of that. Of course, as the business continues to grow, you know, we need to make sure that JJ has the proper supply of cars.

So that's also top of mind for us, and everything else is, you know, we keep, we keep looking at it, and I don't expect big discontinuities, but, you know, we're mindful of where and how the business is performing.

Keith Schoonmaker (Director of Industrials Equity Research)

Very well. Thank you, Luc.

Luc Jobin (Executive VP and CFO)

You're welcome.

Operator (participant)

Thank you. This was our last question. I would now like to turn the meeting back over to Mr. Mongeau.

Claude Mongeau (President and CEO)

All right. Well, thank you, Marcus, and thank you all who listened to this call. We're very pleased with our third quarter results. We have momentum into Q4. Our agenda is working. We're trying to stay focused on safety and solid service to be able to create value for our customers and our shareholders, and it's working. We are looking forward, as I said earlier, next time that we will be together, hopefully basically face-to-face in Toronto at our Analyst Day meeting on December 10th and 11th. So we're looking forward to meet you there and give you a sense of our longer-term agenda, our guidance for 2014, and take your question at that point. With this, have a safe day. Thank you. Thank you very much.

Luc Jobin (Executive VP and CFO)

Thank you.

Operator (participant)

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