Canadian National Railway Company - Q3 2015

Transcript

Operator (participant)

CN's Third Quarter 2015 Financial Results Conference Call will begin momentarily. I would like to remind you that today's remarks contain forward-looking statements within the meaning of applicable securities laws. Such statements are based on assumptions that may not materialize and are subject to risks described in CN's Third Quarter 2015 Financial Results Press Release, and analyst presentation documents that can be found on CN's website. As such, actual results could differ materially. Reconciliation for any non-GAAP measures are also posted on CN's website at www.cn.ca. Please stand by. Your call will begin shortly.

Welcome to the CN Third Quarter 2015 Financial Results Conference Call. I would now like to turn the meeting over to Janet Drysdale, Vice President, Investor Relations. Ladies and gentlemen, Ms. Drysdale.

Janet Drysdale (VP of Investor Relations)

Thank you, Mary. Good afternoon, everyone. Thank you for joining us. I would like to remind you of the comments that have already been made regarding forward-looking statements. With me today is 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 Executive Vice President and Chief Financial Officer, Mr. Luc Jobin.

Luc Jobin (EVP and CFO)

Well, thank you, Janet, and thank you everyone for joining us today for CN's Third Quarter Earnings Results. Let me start off this call by providing you with a few highlights of our outstanding results before I turn it over to Jim and JJ for more details on our operating and commercial performance. Throughout the third quarter, we have been managing tough certainly a tough volume environment, challenging in the sense of weaker volumes. But the vigor of our performance reflects our ability to leverage the strength of our franchise and its diversity. It also demonstrates how this team has been recalibrating resources to drive efficiency. It's equally important to point out that we have achieved this while continuing to balance operational and service excellence in a manner that is consistent with our end-to-end supply chain focus.

This translates into an all-time record operating ratio of 53.8%. That performance also carried through into strong financial results. Our diluted EPS is up 21%, and our year-to-date free cash flow is over $1.7 billion. Let me now hand it over to Jim, who will provide a few key operational highlights for the quarter. Jim?

Jim Vena (EVP and COO)

Thank you very much there, Luc. So if we turn to the Q3 operating highlights, I think this slide really speaks for itself. As JJ will describe in more detail, our workload was down, even with—and even with that headwind, we delivered substantial improvement in all key indicators. We demonstrated the resiliency and effectiveness of our operating model, even in a weaker volume environment. We set new records for car velocity, terminal dwell, locomotive utilization, and yard productivity. We also set a new record for train productivity, a significant accomplishment in the face of a 6% decline in revenue ton miles. All of this was accomplished while continuing to focus on delivering superior end-to-end service to our customers, which allows us, which allows our customers to compete in their markets and support long-term sustainable growth.

Our approach of balancing operational service excellence appears to be working. If you could turn to the next page, I'd like to just spend a minute and maybe talk about a little bit about how we achieved these results. It really comes down to a culture of execution. The operating team, headed up by a strong operating background leaders, is equipped with the information they need to identify opportunities and to continually find new ways to drive incremental efficiency. By pushing the decision-making down to the front line, we're empowering the right people to make the right decisions, and to do so quickly. We have the entire team focused on managing their assets and their costs. At the same time, we have a network team that is working to ensure the entire system is optimized.

It's a top-down, bottom-up view, as well as driven from the top down, to make sure at all levels in the company, we're trying to optimize the operation. As always, safety remains our foundational priority, and we ended the third quarter with a strong overall improvement. To continue our progress, we are rolling out the next phase of our Looking Out for Each Other program, which involves awareness training for thousands of our employees. The goal is simple: we all go home safe at the end of the day after a workday at CN. In my opinion, a culture of safety and team focused on driving efficiency while meeting the service needs of our customers is truly a winning combination. Of course, we are also investing smartly in a pinpoint manner in the future.

Earlier this week, we cut in a new double track piece on the Steelton Hill, and you guys have heard me talk about how important this is on the Chicago to Winnipeg. We removed one of the pinch points that we had in that area. I'm very pleased that this is now in place. Perfect timing in November. Luc, it'll help us through this winter, hopefully. This, along with other pinpointed investments we've made in our network from Edmonton and Winnipeg, and Sidings, and at the border for fluidity for our intermodal business, just keeps us being able to move the product that JJ is selling in an efficient manner. The next couple of quarters, I think we're positioned well.

We have excess locomotives, somewhere around 200, or every day it moves up and down, depending on where the workload is. We have good crew availability. We have reacted quickly, and we've shown that if we need to react, and in fact, year-over-year, we're 1,100 fewer employees. We have still about 800 people laid off, and we'll return them, some of them, through the winter, and as the attrition works out, we'll be calling them back to work. It would be a much easier story if the economy was giving us more upside, but at the end of the day, I think we've shown that we can react properly as an operating team, and I'm very comfortable and very happy with the results that the team was able to deliver this quarter.

So JJ, over to you.

JJ Ruest (EVP and CMO)

Well, thank you, Jim, and great job on that 53.8 operating ratio. Looking over at the revenue, revenue was up 3% from last year. The breakdowns as follow: volume and mix resulted in a 4% drop in our revenue. The carloads were down 82,000 units, but in fairness, a full 62,000 of these carloads were attributed to iron ore shortfall. Same-store price came in at +3.3% all in. That is also inclusive of the August reduction of the regulated grain of -5.6%, and some legacy formula pricing from past merger. The Canadian dollar, at 76.5 cents, added 10% to our revenue. And finally, the lower applicable fuel surcharge reduced revenue by 5%.

Now, I will go through some of the highlights of our revenue on the as-reported basis, that is in Canadian dollars and inclusive of the fuel. Starting with forest product. Lumber and panel revenue rose 16%, driven by strong growth in U.S. housing, partly offset by weak Asian export. Australian wood pulp export benefited, benefited from a pulp mill reopening in northern BC, and our paper volume were down 14%, reflecting steady secular decline in consumption. Intermodal. Overseas revenue increased 5%, driven mostly by U.S. import and export, and an immi- and while our Canadian imports were flat. Overall, domestic intermodal volume were in line with last year. Our Canadian transcontinental volume was up 7% on customers' acceptance of our superior service, while our U.S. transborder volume was down as a result of stronger highway competition.

Truck capacity is currently more readily available, and truck costs, truck costs are down. That is to say, diesel fuel is cheaper, and the Canadian drivers are paid in Canadian funds for their cross-border work. However, the prospect for highway to rail conversion remain positive over the midterm. Automotive, our investment to expand our rail car fleet capacity and the strong vehicle purchase at the dealers produced 13% growth for the segment. Petroleum and Chemical. CN crude oil shipment was sequentially flat with last quarter at 23,300 carload, but down 32% compared to last year. The combined two Canadian railroad third quarter AAR carload for crude declined by roughly 25% or 16,000 carloads vs last year. It's the crude spread that drives the overall industry rail volume, not the rail rate.

Currently, crude by rail volume nomination and crude by rail pricing are increasingly transactional and short-term in nature. In the third quarter, we did conceded some volume to support pricing. LPG and refined product continued to perform well. Plastics also produced solid results. Fertilizer revenue grew 18%, driven by product global demand. Grain, in line with the volume dip of last spring, we saw a 10% drop in Canadian grain revenue due to low grain stock. But our Canadian grain business is now running flat out, and grain stock are available again. U.S. grain business was slightly down, reflecting the permanent closure of a major corn processing plant in Memphis early this year. Metals, minerals, and iron ore. Frac sand revenue declined 11% in the context of reduced oil drilling activities.

Carloads were flat sequentially with last quarter, and about 19,000, but down 22% vs last year. Cheap steel import negatively impacted semi-finished steel volume, scrap iron, and iron ore. We are hoping for some U.S. dumping duty to be in place by next spring. A CN-served iron ore mine closed during August. Please take note for future quarter, the annualized impact of the mine closure is 260,000 carloads, less than $50 million U.S. annualized, and at the average length of haul of 21 miles. This will distort CN corporate result on carloads, as well as business mix till August 2016, when we lap the event. Coal. Canadian coal carloads were down 38% in the quarter, and our future quarter comparable should start to partially stabilize going forward.

Our U.S. coal volume was down, reflecting a secular demand decline from power generation slack, and our exports via the U.S. Gulf terminals were flat compared to last year. Now looking ahead. On the whole, we remain constructive, particularly when it comes to consumer-driven demand, despite weakness in energy and specific commodity markets. The U.S. economy will be a driver of growth in automotive, in vehicle manufacturing, in vehicle sales, and in lumber and panel. To exploit these opportunities, we added 7% to our automotive rail car fleet, and we're also adding 35% to our Toronto auto compound capacity. Regarding lumber, our centerbeam fleet is about 7x bigger than our direct Canadian competitor, and we also added cars to this fleet this year. Port business should also remain vibrant.

Grain and fertilizer should be doing okay, and the same for petrochemical and refined product. Crude, the crude volume will remain under pressure from pipeline capacity, but we do have the incremental rail capacity and the cost base to be a player, and will be a player in the rail transactional game. Our short-term headwind will remain crude, steel, coal, frac sand, and iron ore. The one thing to watch in case of CN for volume is our RTM, focus on our RTM performance. The team is also engaged in pre-selling port capacity expansion, namely at the Mobile, Alabama rail-on-dock expansion, and as you may have seen yesterday, the GCT expansion at Deltaport in Vancouver. The recently announced Trans-Pacific Partnership Trade Agreement, referred to as the TPP, only adds to the value of these pre-selling port expansion campaigns.

In conclusion, we have a very diversified end market portfolio, which carried us well here during the third quarter, and we have the industry best operating costs. We continue to expect pricing above inflation in the range of 3%, and that is because of the negative impact of the revenue grain cap, as well as some long lag fuel component from past merger legacy index that will be transient headwind with us over the next 12 months. We work hand in glove with Jim's operating team on yield management, on cost control, and on further developing our end-to-end supply chain competitive edge. So, Luc?

Luc Jobin (EVP and CFO)

All right, thanks, JJ. Starting on page 12 of the presentation, then let me address the key financial highlights of our strong third quarter performance. As JJ pointed out, revenues were up 3% vs last year to just over $3.2 billion. Fuel lag represented a revenue tailwind of $37 million in the quarter, or $0.02 of EPS higher than last year. While we're on the subject of fuel lag, you should keep in mind that in the fourth quarter this year, this will turn into a revenue headwind vs last year, somewhere in the range of probably $40 million, assuming the WTI remains in the current level of approximately $45 a barrel. Operating income was $1.487 billion, up $200 million or 16% vs last year.

Our operating ratio in the quarter was 53.8%, an all-time record, and this represents a 500 basis points improvement over last year, of which the fuel rate impact represented approximately 200 basis points. Net income stood at $1 billion, up 18%, and diluted EPS reached $1.26, up 21% vs last year. The impact of foreign currency exchange in the quarter was $107 million favorable on net income. Turning to page 13, as Jim indicated, we continued to make significant progress in the quarter in terms of safety, productivity, and cost management. Operating expenses were lower than last year by about $100 million or 5% at $1.735 billion. Expressed on a constant currency basis, however, expenses were actually 14% lower than last year.

At this point, I'll refer to the changes in constant currency. Labor and fringe benefit costs were $588 million. Excluding FX, this is a 6% decrease from last year. This was the product of three elements. First, overall wage costs decreased by 0.5% vs last year, as wage inflation and lower capital credits were more than offset by headcount reduction, along with lower overtime. We had 1,100 less employees at the end of the quarter vs last year, and that's a 4.5% decrease in headcount. In all, we have about 800 employees laid off at the end of September vs 600 at the end of the second quarter. The second element was lower stock-based compensation expense for $42 million of the total labor variance.

The third and last element was a higher pension expense for $12 million. Purchase services and material expenses were $401 million, 3% lower than last year, as we incurred lower third-party costs in the quarter, which were partly offset by increased costs for materials, along with higher repairs and maintenance. The fuel expense stood at $293 million, or 45% lower than last year. Fuel cost was $156 million favorable vs last year. Lower volume accounted for a $19 million betterment, while productivity and a minor inventory adjustment contributed $15 million. Depreciation stood at $287 million, $10 million higher than last year or 4%. This was in large part a function of asset additions, partly offset by the impact of depreciation studies.

Equipment rents at $93 million were $4 million lower than last year or 5%. Last but not least, casualty and other costs were $73 million. That is a $25 million dollar less or lower than last year or 5%. As for the most part, we incurred lower accident-related costs in the quarter. Moving on to cash. We generated free cash flow of over $1.7 billion for the first nine months of the year. This is approximately $300 million lower than last year. We had higher cash flow from operation for $600 million, partly offset by $700 million higher, of higher capital expenditures and lower proceeds from asset disposals. Meanwhile, our balance sheet remains strong, with debt and leverage ratios well within our guidelines.

As for our 2015 financial outlook, we continue to be confident in terms of CN's prospects for the year, notwithstanding the fact that we're experiencing weaker conditions than expected in some markets. As we look to the future, North American economic conditions are favorable, consumer confidence remains solid and should support continued progress in housing, automotive, and intermodal sectors. This should translate into carload volume for the full year to be approximately 2% lower than last year, with pricing in line with our inflation plus policy, as JJ pointed out. Therefore, we are reaffirming our 2015 financial outlook, calling for double-digit EPS growth over the 2014 adjusted diluted EPS of $3.76. We're also maintaining our capital investment program for the year at approximately $2.7 billion.

Furthermore, we continue to pursue our shareholder return agenda, having just completed, in the 12 months ended October 23rd, the repurchase of over 24 million shares for $1.85 billion. Our board of directors just approved a new normal course issuer bid program, allowing the repurchase of up to 33 million shares over the next 12 months, and for which we're setting aside a budget of approximately $2 billion. Our 2015 dividend has increased by 25% this year, and we intend to gradually move towards the 35% payout ratio. We look forward to reviewing our dividend along with our fourth quarter results in late January. On this note, let me close by saying, on behalf of this management team, along with Claude, who's listening to us out there, Claude, that we're very proud of our third quarter results.

Looking ahead, we intend to continue leveraging our great franchise and managing our business to deliver value for our customers and shareholders. We remain committed to our agenda of operational and service excellence, and we're on track to achieve our full year guidance. We'd be happy to take any questions now. Over to you, Mary.

Operator (participant)

Thank you. We will now take questions from the telephone lines. If you have a question and you're using a speakerphone, please lift your handset before making your selection. If you have a question, please press star one on your telephone keypad. If at any time you wish to cancel your question, please press the pound sign. Please press star one at this time if you have a question. There will be a brief pause while the participants register. Thank you for your patience. The first question is from Ken Hoexter from Merrill Lynch. Please go ahead.

Kenneth Hoexter (Analyst)

Great. Good afternoon, Claude, all the best as you, as you recover there. Luc, maybe you could just start with your, your thought that, your last comment there, targeting down 2% volume. That indicates quite a negative fourth quarter, and, and maybe just some early thoughts now as you flow into 2016, at this time, in, in terms of the volume outlook. And I, and I guess within that, it sounded like you were ceding some volume to support pricing. Or, does that mean we're seeing the other rails getting aggressive within that, or is, is that just part of your, your volume outlook?

Luc Jobin (EVP and CFO)

Yeah, let me make a few comments, and then I'll ask JJ to supplement. You know, keep in mind that, you know, what JJ pointed out, which is your carloads in the fourth quarter will be negative. A large impact will be the result of the iron ore closure. So again, you know, don't pay too much attention to the carloads. You should be focusing more on the RTMs. So, and contrary to this quarter, where the RTMs and the carloads were in sync, you will see a different picture, as you look to the fourth quarter. So I would encourage you to focus on the RTMs. They'll be a much better indicator of the volumes that we're taking on.

As it relates to crude, I mean, that has always been a very, competitive category. It was right from the beginning, from the get-go, and, we expect that it will continue to be competitive. Having said that, certainly some of the business is volatile, is spot business, and also what we're seeing is a shift, perhaps away from manifest to more unit trains, which in and of itself will translate into lower prices, as a result of that. So maybe, JJ, if you wanna supplement?

JJ Ruest (EVP and CMO)

Yeah, Ken, for at least for the fourth quarter and maybe for part of next year, you wanna look at our RTM. If you look at week 42, our RTM are -1.8%, and the carload are -8.1%, and that's related directly to this big iron ore mine closure, which is a lot of carload, but it doesn't—it's in the range of $10 million-$12 million per quarter. Regarding volume and how that links to price, you know, the railroad market is very competitive, will always be very competitive. We don't expect anything less.

No, our forecast or, you know, view of what carload will be next year, we don't foresee necessarily shift in market share, and we will make sure we work hard on it, so there's no significant shift in market share.

Kenneth Hoexter (Analyst)

Great. Appreciate the insight. Thanks, Luc. Thanks, JJ.

Operator (participant)

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

Cherilyn Radbourne (Analyst)

Thanks very much. Good afternoon, and congratulations on the quarter.

Luc Jobin (EVP and CFO)

Thank you.

Cherilyn Radbourne (Analyst)

I wanted to ask a question on the cost side, because when we get a quarter like this, where there's a big move in foreign exchange year-over-year, and you get a bit of a shock absorber from stock-based comp, it can be difficult from outside to see how the operations really contributed. So I just wonder if you could give us some insight as to how much credit you can take here, and how much your internal productivity initiatives contributed?

Jim Vena (EVP and COO)

Well, Cherilyn, listen, why don't I start, and then the other guys can jump in if they want. But, I was hoping that with those numbers we presented, for the highlights, nobody was gonna ask me any questions. It's a nice, clean quarter, let's go. But I appreciate the question. So fundamentally, the challenge always is, is when you have a, a lot of puts and takes, it's how's the railroad running itself? And that's what's key, key. And we gave a few of the highlights. I could bore everybody by putting out a whole bunch more, information. But bottom line is, is we were, we were-- the challenge was we had a drop in the amount of GTMs.

So we're working against a 4.8% GTM drop, which is a nice figure that we use instead of the RTMs on, on workload, just because of the mix, how far you're hauling, and everything else. But what we were able to do as an operating team, and really, it's the discussion with JJ and Luc and all of us together, but this is what we've been able to do, just to throw a couple other things. Train starts dropped 13%, with a 4.8% drop. The train miles, we were able to go 4% less. Our train length, which we don't always tell everybody about, was actually up 4%. So more cars on less trains with less miles, helped us being able to do it. And we were absolutely diligent, looking at locomotive velocity up 4%.

GTMs per train hour were just about 10%. So all the metrics, but you don't just stop there, it's how well their bad orders, the number of bad orders and the amount of work and overtime we had there, we were able to drop it, and the fact it dropped double digits, great work by Jim Danowitz and his whole team on the mechanical side. Our old dates, we look at velocity, and if you only look at velocity, what you get is the overall number. But, we also were driving the actual cars that are sitting around the yards a little longer, which we label as old dates, and we're able to drop that number down double digit in the quarter. On top of that, our service metrics, so how are we doing on servicing the customers? Because we wanna look at it end-to-end.

Our destination and origination were up double-digit in performance. So we ran the trains faster, we ran the trains longer, we put more tons on the train, and in the yards, we put the cars through quicker than I've ever seen. So, so when you put that all together, Janet would give me heck if I gave you the actual number, but I'll tell you this much is, is we were able to drop the cost, even though we had a inflation because of the wage increase, we actually were able to drop our costs on a yard and on the road on running trains, close to double-digit. So that's the kind of quarter you wanna deliver at the base of the operation, Cherilyn, hopefully I answered your question.

Cherilyn Radbourne (Analyst)

Great. That's my one. Thank you.

Jim Vena (EVP and COO)

Thank you.

Operator (participant)

Thank you. The following question is from Chris Wetherbee, from Citi. Please go ahead.

Christian Wetherbee (Analyst)

Hey, thanks. Good afternoon, guys. Just wanted to touch a little bit on pricing, if I could. I think you gave some color around the grain impact on pricing and maybe some legacy impact on pricing. But just wanna get a sense of how you're thinking about sort of the pricing environment sequentially as we move through 2015, and maybe if I can convince you to talk a little bit about it in 2016. But just wanna get your sense of sort of what's going on in the market right now competitively in that core pricing.

Jim Vena (EVP and COO)

Starting with the bigger impact, where the core pricing is now at 3.3%, and heading toward 3%, we have about 9% of our business, which is sort of index related, and I would call the Canadian Grain Cap basically an index. In this index, you have a fuel component, which is basically a long lag fuel tail. That's why the Canadian Grain Cap is down to -5.4%-5.6%. August first, it was +4-4.5% before that, because of the drop in fuel last year.

You have a similar thing in some of our life-of-mine contracts that came in as a result of us buying properties back in the days, where you have a long lag fuel component that's finally kicking in in the next 12 months. So we have this transient, you know, digesting these indexes. Then you look at the regular book of business. The regular book of business is still in the range of 3%-4%, you know, maybe not quite as robust as last year or a year and a half, when the rail capacity in North America was snug. I don't believe the rail capacity in North America is snug, maybe some pockets, but typically not.

And then you have these, these one-timers that come in as an index. So that's why I said, you know, we, in some of the same store price, we're heading toward probably more a 3% range, all inclusive, inclusive of this lag and the, you know, the thing that we need to digest, the grain cap here for a period of 12 months.

Christian Wetherbee (Analyst)

Oh, okay. So it sounds like, is it any way you can say sort of equal parts from some of the index or caps vs sort of the relative pricing environment, or is that just a little too granular?

Jim Vena (EVP and COO)

These index, like the grain is negative, and some of these other legacy index and contract also negative. So you need pricing power to be able to offset that and bring them up to a 3, you know, 3-something %. So obviously the marketplace is still positive from a price price take, in carload, definitely, in merchandise, definitely in bulk as well. I mean, we are getting price increase in moving coal, for example.

... And, in intermodal, we are getting price increase, not as much as in cargo, but there is still some price increase across the board. So it's a question of, of how much. I think you also look at what's happening in the trucking industry. The price take in the trucking industry in North America has also been slowed down a bit, and that's reflecting in some of our market, in merchandise and or, domestic intermodal as well.

Christian Wetherbee (Analyst)

All right, great. Thanks so much for the time. Appreciate it.

Operator (participant)

Thank you.

Jim Vena (EVP and COO)

Thank you.

Operator (participant)

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

Walter Spracklin (Analyst)

Yeah, thanks very much. Good afternoon, everyone. So if I could turn, perhaps, Luc, to the CapEx program, and I guess the one key pushback I get from investors on the rail group in general is the capital intensity. And arguably, now that you're seeing volumes come down a little bit and your CapEx programs right at the high end of your, you know, your kind of guided range. Understanding that U.S. dollar plays a part in your program and knowing that's higher for next year, obviously, is there any insight as to whether CapEx can now trend down back toward the lower end, now that we're seeing some volume respite, or do we still see a fairly relatively high CapEx spend going forward?

Luc Jobin (EVP and CFO)

Yeah, Walter, I mean, I think we should probably continue to think about the CapEx at the higher end of the, you know, we typically look to 18%-20% of revenues. Albeit, you know, the revenue, there's now a bit more noise given the fuel surcharge component that's that's out of it. Clearly, you know, a little bit of FX pressure, but I think that's a reasonable range for us to consider. And, you know, we continue to to look at that in somewhat of an opportunistic fashion. I mean, you know, there's a little bit less traffic on the network, so, you know, Jim can can use the opportunity to to concentrate on making the right investment in terms of the infrastructure, hardening our our our track conditions.

And so, you know, and some of the commodity prices are lower. So, you know, we, we always wanna be, a little bit opportunistic when we see these, these changes. So as such, I wouldn't necessarily look for a significant reduction. As far as, as we're concerned, as long as we continue to see a productive way to deploy the capital, you know, that's, that's a good place to be. So I wouldn't expect a major discontinuity there. And certainly, you know, we'll guide, when we get into 2016, we'll guide accordingly. But I would not expect a, a major departure here.

Walter Spracklin (Analyst)

Just to clarify, is the ratio between growth and replacement capital fairly consistent with prior years, or are you bumping, I know you kind of mentioned, but are you bumping the envelope a little bit more on the growth side?

Luc Jobin (EVP and CFO)

We are actually probably, you know, we're gonna look for opportunities. The approach we have, and certainly we tell the whole team is, you know, if we see good growth opportunities, we don't feel constrained. So, you know, if they have the right profile and we think it, you know, they're compelling to add value for the franchise, we're happy to, you know, to push the envelope a little bit here. So we'll see. I mean, we'll share with you guys a little bit more in detail what the mix will be for next year, but the same principles continue to apply.

Walter Spracklin (Analyst)

Okay, thank you very much.

Luc Jobin (EVP and CFO)

Thank you. Welcome.

Operator (participant)

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

Scott Group (Analyst)

Hey, thanks. Good afternoon, guys.

Luc Jobin (EVP and CFO)

Afternoon, Scott.

Jim Vena (EVP and COO)

Afternoon.

Scott Group (Analyst)

So Luc, maybe if you can give us a little bit more color on the guidance for the year. You're so far ahead of that double digit run rate. Can you maybe put some context around fourth quarter? Do you think that double digit earnings growth is a good bogey or target for the fourth quarter? Just any color you can give us on fourth quarter in particular.

Luc Jobin (EVP and CFO)

Yeah, well, you know, Scott, you know, we don't guide on a quarterly basis, so I mean, that always, you know, that always is something that we stay away from. Our annual guidance, as you indicated, calls for double digit. Do we feel good about that guidance at the current time? Absolutely. I mean, I think, with the third quarter and so far, I mean, when you look at the year that we've been clocking in, we feel very comfortable about achieving that. You gotta keep in mind that the fourth quarter last year, we had some very good weather, certainly through December. And we also had revenue growth back then of about 17%. So, all things considered, you need to look at the fourth quarter in terms of some tough comparables.

But as I said, you know, we feel very constructive about our fourth quarter, given the backdrop of the economy. And I think JJ has given you quite a bit of color in terms of where we're seeing the RTMs evolve. So, I would say we're, you know, confident that we'll meet our guideline and clearly, we've got good momentum going into the fourth quarter. So that's the color on that.

Scott Group (Analyst)

Okay. And then if I can just ask one more. So help us put some context around a 53.8 OR this quarter, a 56.4 last quarter. Without changes in fuel and currency, is this a new normal? And if we see volume growth next year, can we kind of start to think about margin improvement beyond that? Or is this just something that doesn't feel sustainable, and there's some unusual things in here? And again, I understand that the fuel and the currency helps, but maybe just outside of changes there.

Luc Jobin (EVP and CFO)

Right. I mean, you know, the biggest one of the big factors, as we all know, this year has been the fuel. But assuming that the fuel would stay at the current level, certainly, you know, we see the scope for a sub-60% OR. And I think those are the conditions and the profile that this organization can deliver. Of course, you'll have the, you know, the seasonal changes. First and fourth quarter typically are a little bit more affected by the weather. But, you know, we're clearly looking at sub-60% OR environment, and FX really is not a significant element there. It's mostly the fuel that can play havoc.

So fuel prices make a significant run up, then, of course, that'll become a bit of a headwind. But, you know, we are, by and large, we are clocking in our record performance, even if you did exclude the fuel component. So, you know, we feel pretty good about our ability to manage both the top line and the bottom line, and continuing to grow the franchise and, and deliver that balance that, you know, JJ and, and Jim have referred to in terms of operational excellence, at the same time as continuing to build value in the service we provide to our customers. So, you know, all in all, you know, I, historically, would call for very low 60 OR. I think clearly the conditions now are for sub 60.

Scott Group (Analyst)

Okay. Thank you, guys.

Luc Jobin (EVP and CFO)

You're welcome.

Operator (participant)

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

Brandon Oglenski (Analyst)

Yep. Well, good afternoon, gentlemen, and congrats on a pretty decent quarter here. I guess Claude has left the team in good hands, and best wishes to him as well. But I wanna follow up Scott's question here. I mean, does this OR outcome, and I do think you do have a little bit more U.S. revenue than you do U.S. expense. I gotta believe FX is helping a little bit here. And maybe, JJ, this question is for you, but does this help you in markets like intermodal, where you can be much more competitive vs a U.S. carrier, just given where exchange rates have gone? And on top of that, the West Coast port issues that we've seen, that maybe you don't deal with in Vancouver. Can you expand on that a little bit?

JJ Ruest (EVP and CMO)

So, so your first question, to clarify, 55% of our revenue are in U.S. dollar, so that's the ratio of our revenue, which are U.S. denominated. In terms of what we exploit, we exploit anything that the economy offer to us, and you know, I call this surfing the wave. And one of the wave which is offered to us right now to surf is the weaker Canadian dollar. So yes, of course, we're driving the U.S. dollar as a competitive edge for as long as it might last, nothing lasts forever, to bring product to U.S. with a higher Canadian component.

So if you are selling lumber to a U.S. housing start from BC, where most of the labor costs and wood costs is in Canadian funds, we really, we really wanna drive that very hard, and that's why we've expanded our centerbeam fleet, to be able to capitalize on both the weak dollar and the strong US housing start. And on the port business, the same thing. It gives it the fact that we price to the US from Canadian port in US funds, and part of our costs are in Canadian funds, allow us to be even more competitive and/or higher yields. Either we get a higher yield, or we can get maybe more car loads. And also, remember, the Canadian port would typically do their contract with their shipping line in Canadian funds.

So when, as the shipping lines are redoing their costing model as to which train they're gonna put which container, which would be dropped on which port, they also reassess. They put the impact of the currency in their own model, all currency around the world, and that's also a positive. So we do exploit the Canadian dollar for what it is, since we no longer have crude at $95 a barrel here. We rail what can be railed, and what can't be railed, we wait for the next cycle.

Brandon Oglenski (Analyst)

Thank you.

Operator (participant)

Thank you. The following question is from Tom Wadowitz, from UBS Securities. Please go ahead.

Thomas Wadewitz (Analyst)

Yeah, good afternoon. And, Claude, wish you a quick recovery, and you know, also congratulations on the strong, strong operating ratio. It's obviously a very impressive number to put up. I wanted to ask you, Jim, on the productivity, the railroad's running very well. What happens in 2016? What do you push on, and how much room is there to go, if the volume environment remains somewhat muted? You know, is it train length and taking on more train starts? Or, you know, where do you go, given that the railroad is already running at a very strong level?

Jim Vena (EVP and COO)

Listen, thank you very much. Great question. So first of all, it's we've been investing back in the plant in places to make us more efficient, whether it's a double track out in the prairies between Edmonton and Winnipeg. It's being able to use the humps more efficiently in Winnipeg and in Chicago. It's the J and the investments that we've had on the J around Chicago to get us quicker. So that gives us a framework, and we'll continue. The double track up to Steelton Hill makes a difference. Tracks at the border, tracks at Pokegama. We've added capacity to make sure that we can grow with the business. What...

I'd like the problem to be next year is that we're up, the economy gives us more business, and we have to react in a positive manner in there. I think we've got the team to do that. Very impressive. Is it gonna always be easy to be able to improve your yard productivity by 10%? No, but I'll take two or three, and we're always working to find that opportunity. I don't think the story's finished. We'll move ahead, and we'll react with whatever kind of business that we have coming online.

Thomas Wadewitz (Analyst)

So, even if you don't get much help on volume next year, you think there's more to go in yard productivity and train length?

Jim Vena (EVP and COO)

... Yeah, our railroad's built with 10,000- to 12,000-foot sidings, double track, and our train length is running around 8,000, so I've got room left to grow.

Luc Jobin (EVP and CFO)

For Jim, there's always room left to grow, so

Jim Vena (EVP and COO)

Especially with the new locomotive.

Luc Jobin (EVP and CFO)

Thank you, Tom.

Thomas Wadewitz (Analyst)

Okay, thanks for the time.

Luc Jobin (EVP and CFO)

Thank you.

Operator (participant)

Thank you. The following question is from Jason Seidl from Cowen and Company. Please go ahead.

Jason Seidl (Analyst)

Thank you very much. Hey, everyone. Just wanna go back to the comments on casualty and other, I mean, dropping 16%. It sounds like you're gonna get some benefit going forward from those good results when you look at the actuarials. Just wanted to know if you could frame up some comments going forward for that line item.

Luc Jobin (EVP and CFO)

Yeah, I think, you know, there really wasn't much in terms of actual results, reflected in the third quarter, Jason. So, essentially, the major component was lower accident-related costs. By and large, what I would say is, again, this can be a little bit bumpy in terms of quarter to quarter, but I continue to, you know, kind of guide towards roughly $90 million a quarter on average, appears to be probably a reasonable number to anchor on. So that's what I would, at this point, suggest you keep in mind.

Jason Seidl (Analyst)

Okay. And I guess the second one here on the consumption in terms of fuel, you had obviously a nice savings. Is that something that we should look at going forward in terms of gallons consumed? Obviously, it'll move around depending upon your volume type, but you had a pretty good number in the quarter there.

Luc Jobin (EVP and CFO)

Yeah, the number on the quarter, as I mentioned, was a component of two things. About half of the improvement was attributable to a one-time inventory adjustment, and the other half-

Jason Seidl (Analyst)

Mm-hmm

Luc Jobin (EVP and CFO)

... was actually a very good, you know, productivity, fuel productivity, in and of itself. Going forward, I think, you know, longer term, we continue to look at somewhere around a 1.5% type of improvement. Now, that's challenging, given the mix and, you know, but, you know, our friends in operation, and Jim, certainly at the helm, are keen to take on the challenge. And, you know, we continue to shine in that particular area.

Jason Seidl (Analyst)

Yeah, you do. Well, listen, guys, thanks for the time, and my best wishes to the close.

Luc Jobin (EVP and CFO)

All right. Thanks, Jason.

Jason Seidl (Analyst)

Thank you.

Operator (participant)

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

Benoit Poirier (Analyst)

Yes, good afternoon, gentlemen. I was wondering if you could provide, JJ, maybe more comments on the intermodal growth, especially for 2016. I'm just wondering, given the expansion plan we've seen at Vancouver, Halifax, and Rupert, whether the ports are still expanding at the same pace, given that there are some slowdown in the intermodal growth.

JJ Ruest (EVP and CMO)

So I think, Benoit, both Rupert and also at Deltaport are running pretty close to capacity as a terminal operator. So our success will partly depend on how much capacity they can offer in terms of rail loading. But there's still some juice at Deltaport for 2016, a little bit of juice at Rupert for 2016. The fourth quarter, the third and fourth quarter, our business has been growing at Halifax as a result of the two new vessel call that the Port of Halifax been attracting. We also have good hope for U.S. Midwest to be a play, a growth area for the Port of Montreal and the Port of Halifax. Going back to comment about the Canadian dollar this week, so Canadian port, Canadian railroad should capitalize on that, short term.

And on the domestic side, it will be more in line with what the Canadian economy can offer and what kind of service we can offer vs the customer's next best choice. So intermodal next year will grow, maybe more so on the international side than the domestic side. And 2017, this is when we see the capacity coming up at Rupert, coming up at Deltaport. We should have more traction by then at Mobile, and 2017 should be a fairly promising year for CN in the intermodal.

Benoit Poirier (Analyst)

Okay, perfect. And just quickly, was there any market share gain impacting your current, intermodal volume?

JJ Ruest (EVP and CMO)

The, if you're talking the third quarter?

Benoit Poirier (Analyst)

Yeah, Q4, the latest volumes we've seen, it's still robust, so I was wondering if there was any market share gain?

JJ Ruest (EVP and CMO)

I wouldn't call-- No, no.

Benoit Poirier (Analyst)

No.

JJ Ruest (EVP and CMO)

In the third and fourth quarter, nothing, nothing to, you know, write to your mother. Nothing substantial.

Benoit Poirier (Analyst)

Okay.

JJ Ruest (EVP and CMO)

Nothing substantial. All right, Benoit. Thank you.

Benoit Poirier (Analyst)

Thanks for the time.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The following question is from Alex Vecchio from Morgan Stanley. Please go ahead.

Alex Vecchio (Analyst)

Hey there. Good afternoon. Thanks for taking the question. I wanted to just clarify the commentary on the 3% pricing going forward. Is that something you expect to continue into 2016? And then within that context, where are your expectations for broader rail inflation next year? And what I'm ultimately trying to get at is, you know, it sounds like you're still getting inflation plus pricing, but how do we think about that spread above inflation in terms of, is that narrowing next year, or expanding, or staying the same? Just any commentary or thoughts on that would be helpful.

JJ Ruest (EVP and CMO)

Well, Alex, I'm not in charge of guidance at CN. I leave that to Janet and Luc, and they do a good job at that. For the fourth quarter, we feel that, by the time you add the -5.6 on the grain cap and some, for example, the BC Rail, the haulage, which is a haulage put in place when we merged, is also generating -10%. You add that plus inflation, plus pricing, this way you get, we think, in a weighted average, 3%. And we, we still have some of these legacy index, including the grain cap-...

that will be transient headwind, at least for the first six months of next year, maybe the first nine months, without telling you what next year will be, you can have a sense of how many months we have, where we need to kind of work through these long lag, fuel effect in these index. And after that, after that, my crystal ball has never mattered more than three months, two, well, months at a time. So I was not able to call crude when it collapsed. I'm not sure we're gonna- I'm gonna call 2017.

Luc Jobin (EVP and CFO)

Alex, this is Luc. Just in terms of general rail inflation, of course, you know, the labor component is running at 3%. Fortunately, what we are seeing is, you know, more reasonable prices in terms of supplies, and that probably is running a little bit below 2%. Depends on the commodity, of course, but by and large, you know, we're still our inflation plus policy pricing is still intact.

Alex Vecchio (Analyst)

Great. Thanks very much.

Luc Jobin (EVP and CFO)

Thank you.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The following question is from Matt Troy, from Nomura. Please go ahead.

Matthew Troy (Analyst)

Yeah, thanks. Just wanted to ask a near-term question on intermodal. We hear so much about a retail overhang here in the States. We hear about recessionary conditions in Canada. Just curious, what you're hearing from your customers about the potential for any peak at all or a mini peak in the next couple of months, given that there are moving parts and pieces, you had port diversions last year, which will obscure some of the comps. But I just wanted to get a sense from your end market read, perhaps, JJ, you know, should we expect to see this typical seasonal ramp, or do inventory levels limit or gate what we might see in terms of a pickup?

JJ Ruest (EVP and CMO)

Well, thank you, Matt. It's JJ. Yeah, we are already, you know, well into October, which mean we should already be well into this peak. Otherwise, the product will not be on the shelf while customer want to buy it. So there's not much of a peak, frankly, so far. There's not much of a peak. We're not getting the sense from the customer there's a peak coming. If it'd be coming, it'd already be on the vessel, in the ocean, and dropping it on us three weeks from now. Just broadly, one thing that we're not too sure about the fourth quarter is what will the last two weeks of quarter look like? And that's maybe more of a general issue that also include the manufacturing.

If the economy is to be a little weak, what would a producer of steel, lumber, or somebody who buy these commodities, same thing for a retailer, do they want to finish the year with high inventory? Or are they gonna take a pause in the last two or three weeks of the year to kind of deplete what they have on hand and restart placing orders for January one? So last year, December was a very strong month for us. I hope this year is the same, but that would also mean that people will keep replenishing inventory at the same pace that they're doing right now. We'll see.

Matthew Troy (Analyst)

Okay, great.

JJ Ruest (EVP and CMO)

what they do.

Matthew Troy (Analyst)

Okay, great. And then just in that same vein, the J.B. Hunt partnership, I know you went into great detail at the analyst meeting, but it's been a couple of months. Just curious, in terms of the pacing and roadmap there, have you learned anything new, anything else you can share with us with respect to the J.B. Hunt partnership and some of the opportunities you might be able to exploit or capitalize upon over the next, let's call it, three to six quarters? Thanks for the time.

JJ Ruest (EVP and CMO)

Thank you. So on J.B. Hunt, we're extremely proud of the partnership we're building with them over time. As I said earlier, right now, the cross-border business is challenged by over-the-road competition, the weaker fuel, and the Canadian dollars for the drivers. We are growing our business with some specific partners, but in total, it's slightly down. So this will take a little time before we can digest the resetting of the capacity of the trucking industry, which is obviously, today, more readily available, as well as the resetting of the trucking firm we do business from Canada to the U.S. But it will happen, you know, we're in this for the long run.

Matthew Troy (Analyst)

Thank you.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

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

Matthew Troy (Analyst)

Thanks for taking my question. So I wanted to ask another one on intermodal. You know, we've obviously seen the pace of growth decelerate in the last couple of quarters for the reasons that you just highlighted. But as we think longer term, you know, whether it's the initiatives related to the port expansions and the partnership with J.B. Hunt, what's the best way to think about a sustainable growth rate for the business in the mid to longer term? Do you think, you know, high single digits is something that you guys can sustain over the next two to three years?

JJ Ruest (EVP and CMO)

We've always said intermodal is probably one of the, potentially one of our fastest growth business. So right now, it stands at 23% of our third quarter result. You would think over time, it sort of climbs, get up from 23 to bigger numbers, as coal, for example, at CN, goes from 5% to maybe 3.5% at some point. So it will outpace the growth of other business segment of CN, and it should also outpace the growth of the economy. And we would like to think that the partnership that we do with the port and the investment we do inland to create new terminal, new catchment area, that will also allow us to also outpace, you know, market share vs those that we compete.

So we're very positive, constructive about intermodal, and we put a lot of effort in creating a mousetrap that's as good as any.

Allison Landry (Analyst)

Okay. And, as a follow-up question, thinking about the operating ratio sequentially in the fourth quarter, given that second and third quarters saw above average improvement relative to historical seasonality, you know, I realize that there are puts and takes with fuel, and you mentioned weather, but at this point, would you expect the, you know, normal sequential OR deterioration to be, you know, a little bit worse than normal?

Luc Jobin (EVP and CFO)

... Well, I think, you know, we'll have to see. I, again, don't have a good crystal ball in terms of predicting weather. And, you know, every time we get out there, we certainly aim for the best OR we can, and we deal with the circumstances that are there. So, you know, no specific guidance there. You should expect a little bit of seasonal erosion, and we'll see where we end up.

JJ Ruest (EVP and CMO)

You know, the fourth quarter is not an easy one to call. Right now, the railroad's running real clean, and expenses are where they should be on the expense side. But come November, December in Canada, you never know where you are. So the best bet is to look at history and say, "What's the change that normally happens fourth quarter?

Allison Landry (Analyst)

Okay, great. Thank you.

Luc Jobin (EVP and CFO)

Thank you.

JJ Ruest (EVP and CMO)

Thank you.

Operator (participant)

Thank you. The next question is from Tom Kim from Goldman Sachs. Please go ahead.

Thomas Kim (Analyst)

Thanks very much for the time here. Excellent results. Obviously, you know, tremendous performance and improved productivity. And I guess, as you think about the headcount going into year-end, would you be able to provide a little bit of guidance in terms of what you're expecting to end the year at? And to what extent can you give us some initial guide for 2016 on headcount? Thanks.

Luc Jobin (EVP and CFO)

Yeah, I think, you know, as we pointed out, I mean, we were sequentially down in the third quarter vs the second. If you look compared to last year, you know, we were about 4.5% down. I would expect that in the fourth quarter, we'll probably be about 4.5%-5% down vs the prior year. You know, Jim pointed out, I mean, we'll be recalling a few, a few people to help us through the winter. So that'll be a little bit of a factor, but still, you know, great productivity. And, you know, we, it's still a bit early. I mean, I think we're, we're looking to 2016, and we'll be providing a little bit more clearer guidance.

So right now, what I can tell you is we're gonna maintain as much productivity as the circumstances require. The good news is, and Jim mentioned it, you know, we've got people that we can recall quickly. We've got the locomotives, and we certainly have the equipment, and JJ commented on that. So, you know, we're prepared to respond very quickly to market conditions, and you know, we're hopeful that you know, 2016 will see some upside. So, you know, we'll go from there.

Thomas Kim (Analyst)

Thanks very much.

Luc Jobin (EVP and CFO)

Thanks.

Operator (participant)

Thank you. The following question is from David Tyerman from Canaccord Genuity. Please go ahead.

David Tyerman (Analyst)

Yes, good afternoon. I just wanted to get some more thoughts on grain, energy, and coal. Grain sounds like it's running well right now, but the harvest wasn't so large in Canada. So how long can we go at this rate? On energy, where are we heading right now? Are we bottomed out, do you think, or could the various energy areas go down further? And the same thing on coal, could we continue to see further declines? It sounds like it's possible from your earlier comment.

JJ Ruest (EVP and CMO)

So on grain, on the CN network, we're more north. Our crop was harvested a little later, so that showed up in our third quarter result. We had, we had to wait a little longer to finally get the new crop. In the fourth quarter, there's enough grain out there in our catchment to keep us busy for the fourth quarter and the first quarter. So sometime next year, I guess, spring and summer, the fact the Canadian crop right now is designated to be below the five-year average, eventually will have an impact in 2016, post-wintertime. On coal, there might be some more further erosion.

Our CN coal business, especially down out of the West Coast, and we're down to, I think, only 1, 1 and a bit% of our revenue is Canadian export coal. Can't go very much lower, but it could. And on energy, I think it's the wild card, right? So on energy, we'll do. We're gonna be Johnny on the spot and move whatever business is offered to us and compete hard for it. And if we need to do dynamic pricing, we'll be very dynamic.

David Tyerman (Analyst)

Okay, very good. Thank you.

JJ Ruest (EVP and CMO)

Thank you.

Luc Jobin (EVP and CFO)

That's helpful.

Operator (participant)

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

David Vernon (Analyst)

Hey, good afternoon, guys, and thanks for taking the question. Question for Luc on the balance sheet. You know, as you guys are looking to increase the payout ratio up to 35%, should we be expecting the rate of share repurchase to maybe even moderate over time, or do you think you can offset that through earnings growth and added leverage?

Luc Jobin (EVP and CFO)

Well, I mean, I think, you know, we have a pretty steady policy in terms of returning, you know, return to shareholders. So we're trying to balance, you know, the dividends with the buyback. We have been growing the stock buyback, and really only, you know, we're out of the market in the dark days of the recession in 2008 and a portion in 2009. So, you know, we'll look to continue to grow progressively the stock buyback. There's a little bit of releveraging that happens as a result. On the dividends, again, I mean, there's a very good track record, 17% growth since the IPO, so that's, you know, 20 years in the making.

We continue to drive towards the 35% payout, which implies that, you know, we're gonna be increasing dividends slightly faster than earnings in the next little while. So I think it's all good. I think, you know, we take a very measured and balanced approach to all of these things. So I think our shareholders ought to look forward to certainly good continuity in that sense.

David Vernon (Analyst)

The level of leverage you've got on the balance sheet right now, adjusted debt to cap or debt to EBITDA, you feel like is kind of at the upper level, or you think you can push that forward a little bit more?

Luc Jobin (EVP and CFO)

Oh, it could be, it could be pushed higher, there's no question. But again, that's, you know, we look for potential opportunities to continue to grow the franchise. So you know, that flexibility can be tremendously helpful when, you know, strategic opportunities come about. So we're mindful of, you know, driving towards a little bit more leverage on the balance sheet, but we also wanna be in a position to exploit opportunities as they come along. So it's a combination of both.

David Vernon (Analyst)

Excellent. Thanks very much for the time, guys.

Luc Jobin (EVP and CFO)

Thank you, Vernon.

Operator (participant)

Thank you. Thank you.

Thank you. This will conclude today's question and answer session. I would now like to turn the meeting back over to Luc Jobin.

Luc Jobin (EVP and CFO)

All right, Mary, thank you very much for all of you that joined in. As I said, we're very pleased with our third quarter performance. I mean, this is true CN performance, whether the markets are up or down, you know, we go at it hard and, you know, we're always focused on our customers first and foremost, and creating good, sustainable, long-term value for them as they try to grow in their markets. As well as, we keep an eye on the bottom line and are mindful of the confidence that our shareholders are placing on us.

You know, we do look forward to sharing with you our fourth quarter results at the same time as we'll be providing guidance and also sharing with you a dividend, you know, where and how our dividend will evolve in 2016. So, we look forward to talking with you folks again sometime in late January. In the meantime, everybody be safe out there. Thank you very much.

JJ Ruest (EVP and CMO)

Thank you.

Jim Vena (EVP and COO)

Thank you.

Operator (participant)

Thank you. This concludes today's conference call. Please disconnect your lines at this time.