Canadian Pacific Kansas City - Q4 2013

Transcript

Operator (participant)

Morning. My name is Erin, and I'll be your conference operator today. At this time, I'd like to welcome everyone to Canadian Pacific's Fourth Quarter 2013 Conference Call. The slides accompanying today's call are available at www.cpr.ca. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question-and-answer session. If you'd like to ask a question, simply press star and then the number one on your telephone keypad. If you'd like to withdraw your question, press the pound key. I'd like to introduce Nadeem Velani, AVP Investor Relations, to begin the conference.

Nadeem Velani (Head of Investor Relations)

Thank you, Erin. Good morning, and thanks for joining us. I'm proud to have with me here today Hunter Harrison, our CEO; Keith Creel, President and Chief Operating Officer; Jane O'Hagan, EVP and Chief Marketing Officer; and Bart Demosky, our EVP and Chief Financial Officer. Before we begin, I want to remind you this presentation contains forward-looking information. Actual results may differ materially. The risks, uncertainties, and other factors that could influence actual results are described on Slide two in the press release and in the MD&A filed with Canadian and U.S. regulators. This presentation also contains non-GAAP measures outlined on Slide three. The formal remarks will be followed by Q&A. We would appreciate if you limited your questions to strategic items, and if you could have any modeling questions, please follow up with Investor Relations after the conference call. It is now my pleasure to introduce our CEO, Mr.

Hunter Harrison.

Hunter Harrison (CEO)

Thank you, Nadeem, and welcome to everyone. We got a lot of ground to cover today, so I'm not gonna be redundant with the presentations that my colleague's gonna give here, but just suffice it to say that I was extremely pleased with the quarterly and annual results. I think we exceeded most expectations. I think that, I think we've assembled now a team of railroaders that is second to none in the world. And I think that, as we go through the presentation today and talk about guidance in the future, that it will give you even more confidence in what this team has got the ability to produce.

Let me just highlight one thing that I was extremely pleased with, that took place right at the end of fourth quarter and right at the first of the year is we brought on a new Executive Vice President and Chief Financial Officer, Bart Demosky, who came to us from Suncor. We did extensive searches all over North America for a longer period of time than I would have liked to have done, but it was worth the wait because I'm convinced now that we could not have gotten a better candidate. Just so happened that he happened to be a neighbor here in Calgary. He has hit the ground running. He's a quick learner, as you will see by his presentation today. He's getting a grasp of the business, and he's become an integral part of this team. So, welcome, Bart, to the team. Nice to have you.

With that, let me turn it over to Keith to make a few comments on the operating results.

Keith Creel (President and COO)

Okay. Thanks, Hunter. I'm just gonna highlight some of the key points of the quarter, some of the things we're most proud of, and save any expansion or questions for the Q&A time. Overall, very impressed with the operating team's performance in the fourth quarter in spite of some pretty tough comparables. We did have the counterimpact last year, fourth quarter 2012, with the hump yards and some of those things that you'd put into play, Hunter. So the bar was raised for us this year, but this team has met exceeded those challenges. We drove additional improvements in train length, weight, and fuel, again, in spite of the comparables and in spite of the weather challenges, which kicked in and stayed in December. Strong volumes in the first two months helped drive a lot of the operating leverage, with RTMs up significantly, about 9%.

Until Mother Nature started throwing some curveballs at us in December, we did have some headwinds there that we had to deal with, which limited some of the productivity gains and impacted the service offering. So a little bit of impact on the operating efficiency side as well as on the revenue side there in December. But in spite of that, closed the quarter very strongly, not losing any ground to a record performance in third quarter at a 65.9. So something we're very, very proud of that this operating team produced. Some of the leverage, key highlights there, fuel continued to improve dramatically year over year, by increasing our train weight, spinning these locomotives faster, and aggressive on the fuel conservation side, 7.8% improvement versus 2012. A little bit more excited that we closed the gap to fast becoming best in class.

2012, we're about 12% behind best in class, third best in industry. 2013, we closed the year out only 4% off of best in class and second best in the industry. Rest assured, we've got line of sight to be in best in class by the end of 2014. On the safety side, another very encouraging story, fourth quarter. Best fourth quarter, best quarter overall safety performance on the train accident side in the past three years, about a 20% improvement over 2012. And more importantly, we as we told the market, back at the end of the first half of the year, some of the challenges we had, we were confident with our investments, through technology, through our physical plan improvements, as well as our culture changes, driving rules compliance, and, and safety, we would see a benefit. We closed that gap.

We finished the year just a little off, almost flat, with 2012, which was a record year. So very encouraging, a lot driven by, and we're carrying that momentum into 2014, having so far a very encouraging safety performance from a derailment standpoint, accident standpoint in 2014. So with that said, 2014, another strong year, much still left to do, more to come. We've invested quite a bit in 2013 in sidings, which came on late in the year, wouldn't be able to convert. Expect this operating team to convert that in 2014, taking out additional train starts, driving some more velocity improvements, some more locomotive productivity improvements, train weight, and length improvements. Focusing on our yards, I'll remind you, the whiteboard sessions we did last year, those kicked in, certainly in spades, second half, comparable-wise, though first half, we didn't talk about how the benefit of those.

We will realize the benefits of those operational improvements, with train mile reductions and all the benefits of that, first half of 2014. As we look at 2014 from a capital investment standpoint, we're gonna continue to strategically invest in our network to increase the reliability, to increase the safety. We're investing in CTC. We're investing in additional steel. We're investing in additional 11 sidings by the end of the year, with a focus instead of bringing all those sidings on toward the end of the year, we're gonna pick the ones strategically that give us the most bang for the buck, from a velocity standpoint, from a service reliability standpoint, and concentrate our assets and resources to bringing them online based on that sequence in priority through the year.

So we'll start to see some of those those gains a little bit earlier than we would have otherwise. So with that said, very, very excited about 2014, about the abilities and the opportunities that are out there. I'll turn it over to Jane to comment on how she's gonna convert that in the marketplace.

Jane O'Hagan (EVP and CMO)

Yes. Good morning. I'm pleased to announce that we delivered 8% revenue growth in 2013. Specifically on the quarter, we continued to improve the quality of revenue and to deliver on our growth initiatives, giving us a record revenue performance with 7% growth over Q4 2012. Our average revenue per car was up 6%, and our renewal pricing came in above our target range of 3%-4%. Demand remains strong, but as Keith indicated, volume softened toward the end of the quarter as the entire supply chain was impacted by poor weather conditions experienced across North America. For 2014, we are targeting 6%-7% revenue growth. As further guidance, I'll note that a 0.01 drop in the value of the Canadian dollar versus the U.S. dollar has a positive annualized revenue impact of about CAD 35 million.

Turning to 2013 highlights of the business, I'll report revenues on a currency-adjusted basis. Let's start with grain. Our Q4 results saw revenue up 5%. With the exceptional Western Canadian crop, estimated to be 79 million tons, or 27% higher than the previous record, we had a strong export program moving 12% more grain through Vancouver in Q4 2013 than in 2012. Our carload decline of 1% reflects lower demand in the U.S. Midwest relative to Q4 2012, when we had a significant increase in the volume we shipped to domestic U.S. markets we traditionally don't serve. Average revenue per car was up 9% as pricing gains were achieved in both Canada and the United States. Our outlook? We see a return to normal U.S. conditions combined with the record crop and strong demand in Canada that will present upside opportunity through 2014 for our entire grain franchise.

Now turning to fertilizers and sulfur. In Q4, we were down 9% in revenue, but despite global market uncertainty, our export potash volume increased strongly against a relatively weak Q4 2012. Domestic fertilizer weakness resulting from a late harvest and a small application window offset gains in potash exports. The international potash market and prices began to stabilize at the end of the quarter. So as we look to the outlook, there's strong demand fundamentals for domestic fertilizer application as both farm incomes and grain prices are up and because demand was constrained during the fourth quarter. The return of cooperation between Russian potash producers creates greater price certainty, and this stability sets the stage for international buyers to purchase with a lot more confidence. We expect this development will drive a recovery in export volumes similar to the experience in the first half of 2013.

As we turn to coal, Q4 results: revenue was flat year-over-year. As I advised last quarter, met coal exports drove an increase in our Canadian volume while a decline in U.S. coal traffic related to continued weakness in electric utility demand persisted. The decline in short-haul thermal traffic and the increase in longer-haul export met coal resulted in a 6% increase in the revenue per car. As we look to the outlook, Teck holds a strong position in the met export coal market, both with respect to market diversity and in cost performance. The increased capacity is expected to translate into volume growth for CP's Canadian franchise. U.S. volume growth is uncertain as questions remain about turnarounds in the domestic and export demand for thermal coal. Now let's turn to intermodal. Q4 results: revenue was 3% lower year-over-year.

I consider 2013 intermodal performance to be a success as by year-end, we had improved the quality of the revenue, closed the revenue gap created by facility closure, service discontinuance, and book of business rebalancing. As I look toward the outlook for 2014, I wanna reiterate that we're growing in the right lanes with the right customers aligned to our service capability and our network strength. We're taking advantage of our service improvements by growing where we have competitive advantage, where we can price for value, and improve the operating income of the business. We expect intermodal revenues to be down for the year, reflecting in part the OOCL business that is shifting to CN.

We will meet the same intermodal challenge in 2014 that we successfully addressed in 2013 to continue to improve the operating income we generate from this business and to fill any revenue gaps that appear. The overall book of business will continue to change, both as international contracts shift between carriers and as the composition of our domestic book changes. Our book will remain strong as we continue to focus on the segments and on the customers that drive the greatest value to both parties. Now, as I turn to industrial and consumer products, our Q4 results, we were up 18% in revenue. We moved 25,000 carloads of crude in Q4 for a total of 90,000 carloads for the year. Our Q4 RTMs were up 20% due to gains in crude oil and increases of frac sand originating from mines that continue to ramp up their volumes.

As I look to the outlook, our crude oil customers have confirmed they continue to value rail service, and facility development and the expansion is evidence of their commitment. Our capacity buildouts are proceeding at a more measured pace, and we continue to see increasing volumes of heavy crude moving with different economics and drivers of demand than the lighter Bakken crudes we predominantly move today. We will continue to mitigate our risk by advancing growth in careful stages that accommodate investment, the market commitments of our customers, and choose those that provide good margins. While we carefully build the capacity to handle consistent term volumes, we also have the capability to move volume that responds to the movement of spreads. We have announced three new frac sand facilities on our network in Wisconsin. The new capacity will produce high-quality product and will be phased in throughout the year.

Our other industrial products will trend with GDP growth. In conclusion, I'm looking forward to 2014. Our operating team has set the table for us, and we will now self-service with sustained profitability. While we have some revenue headwinds from intermodal and automotive contract shifts, I'm confident that we can deliver revenue growth of 6%-7% in 2014. We're starting this year off with a new marketing and sales organization that we rolled out in Q4, and we're kicking off next week with a new incentive compensation program that will reward profitable growth. The team is focused. We're up to the challenge. With that, I'm gonna turn it over to Bart.

Bart Demosky (EVP and CFO)

Well, thank you, Jane. And good morning, everyone. I thought I'd maybe just start off by reiterating a couple things. And first and foremost, just how excited I am to be on board here at CP. Hunter gave some very kind comments at the beginning there, and I'm looking forward to being up to the challenge. It's a great opportunity, and one I'm really looking forward to. I'm also excited to be here on the call with all of you today. It is only day 18 for me, so I am gonna keep my comments at a fairly high level and focus on three things. First, I'll just cover off a few of the key metrics for you.

I did want to spend some time on operating expenses because that is such an important part of the story and the value contribution here. And there's continued great work going on there. And then I am going to touch on free cash flow. I know that's an area of interest for many of you, so I'll provide you with a few comments there. So just to kick things off, it was a very, very strong quarter. Adjusting for significant items, our operating income was up a full 45%. Net income was up a full 51%, resulting in EPS of $1.91. And we had an all-time operating record of 65.9%, an improvement of a full 890 basis points year-over-year. Now there are a couple of below-the-line items that I did want to draw your attention to. One is other charges.

that typically has a run rate of about CAD 3 million in a quarter. We were impacted by, by foreign exchange this quarter, so in the quarter, that cost us about an additional CAD $3 million. And then if you look at CP's effective tax rate, it came in to just over 28% for the quarter. And that was higher than our guidance that we provided previously of 25%-27%. Two things happening there. One was the BC tax rate increase that occurred earlier in the year. And then, on a good news story, of course, we're, we're, we're seeing higher revenues in the United States, which is positive, but it does attract a higher tax rate. Onto the operating expenses side, I am gonna speak from the perspective of an FX-adjusted basis. So just keeping that in mind as you, you listen to my comments.

In Q4, foreign exchange did have a positive impact on our revenues of about $43 million. Likewise, it increased our expenses by $29 million. A couple of metrics to leave with you. In total, for every 1 cent the Canadian dollar depreciates, it increases our annual revenues by about $35 million. Jane had covered that earlier. And our expenses by about $20 million. Another good rule of thumb is that for every 1 cent change in the exchange rate, it equates to about a $0.05 change in EPS for us. And for reference, we have set our guidance for the year using a $1.05 exchange rate. So we do have a tailwind, right now, as we start the year. We saw continued improvement on the comp and benefits side this quarter. And that's despite higher stock-based comp volumes.

But that was more than offset by significant efficiencies that were delivered. Stock-based comp headwinds, to be frank, those are a quality problem, because that means all shareholders are winning. And year-over-year, it was only a $9 million headwind, but sequentially, it was about a $25 million drag. Going forward, just to give you a guideline, you can expect our stock-based comp sensitivity to be about 850,000 of additional expense for every $1 increase in the share price. Now before I wrap up on comp and benefits, I should note that, as a result of a higher discount rate but also very, very strong portfolio performance, you know, we experienced a 15% return on a portfolio basis for our pension assets in the year.

As a result, we are expecting pension income of CAD 52 million in 2014 versus an expense of CAD 45 million in 2013. As you all know, pension accounting, it is a complex, it is complex. There's lots of variables. But at this point in time, we would expect to be in an income position in 2015 as well. And we're guiding right now to about CAD 50 million in income. In terms of the balance sheet, and pension impacts, you will note that we now have a pension asset recorded.

That would be the first time in a long time for the company, I would expect. This represents an improvement, or a movement, I should say, from a CAD 800 million deficit position in 2012 to a surplus in 2013. A couple of factors driving that. One, I mentioned already, which is the favorable discount rates and the very favorable portfolio returns.

But also, we did have some plan changes, and there were significant prepayments made in previous years. We are just running the numbers right now from an actuarial basis, but at this point, we believe that we no longer have a solvency deficit. On the fuel front, the 7% fuel productivity improvement that Keith mentioned more than offset the higher fuel prices that we saw and the higher volumes we experienced in the quarter. The increase in material expenses primarily was due to volume, and there was some seasonal weather impact in there as well. Equipment rents continue to be a very positive story, with productivity more than offsetting volumes that increased in the quarter. Purchased services saw a significant decline this quarter. And there's a couple things going on there.

On the efficiency side, insourcing initiatives drove lower IT costs, and we're gonna continue to see benefits there as well as third-party maintenance costs. We also benefited from a bit higher land sales than we would normally experience, but also lower casualty costs in the quarter. I'm gonna close out with a comment on free cash. In 2013, we generated CAD 530 million of free cash. That's after dividends. That's in spite of our CapEx ending the year just slightly higher than the CAD 1.2 billion we guided to. The company is clearly in the strongest cash position and free cash generation position in its history, which makes me feel pretty good as a CFO about my timing on joining. For anybody who knows my background, I'm not a fan of sitting on idle cash.

So while I'm not in a position today to guide you on our use of cash plans beyond those already outlined, I can say that we are taking a very close look at our options. And, I'll be discussing those with Hunter and Keith and the board in very short order. So we should be back, relatively soon with some plans there. With that, thank you very much. Great to be on the call. Looking forward to meeting as many of you personally as I can. And with that, I'll hand it back over to Hunter.

Hunter Harrison (CEO)

Thanks, Bart. Good start here. So let me kinda pull all this together and, and talk about a little data for, for 2014. I'm trusting you've seen the numbers. On the revenue front, we're talking about 6%-7%, year-over-year, revenue increase. I know there's gonna be a little probably discussions on that, whether that could be described by some as, as maybe a little conservative. I think there's, there's a lot of moving parts right now that we don't really have our hand wrapped around very good. One is the what the Canadian dollar's gonna do. Bart described to you some of the volatility associated there, what's gonna happen in China. Although I think that will have if there is negative impact there, it won't impact us as, as in as it does others.

On the cost front, we expect a breakthrough, 65 from an operating ratio standpoint that, effectively a full two years plus, ahead of the four-year plan. I think that we look for earnings growth in excess of 30%, which makes me even more enthusiastic about where I am with the organization. This looks like it's gonna be a long, good run. I hate to leave in the middle of it. But that will be determined as Keith makes faces at me in the background here. I think that's a couple other things that you'll probably have questions about, so I'm gonna talk about a little bit about them. Clearly, we, as Keith mentioned, had some impact from the winter conditions here in Canada on a year-over-year basis.

It really was the last three weeks of December that caused the major part of that issue. But I would hasten to add that those issues continue in January. And they're in a location in basically—it's central Canada and the Midwest. So we kinda cut the network right in two. But in spite of that, we have made some changes in the operating plan. And I think Keith and his team are dealing with that very well. On the headcount front, the number stands today at about 4,750 or thereabouts. I would certainly expect by year-end 2014, we'll clearly break through 5,000+. And there's some questions there, but that'll be a very, very positive hit. And then we're having some challenges, but you always do with some SAP cutovers.

But when we get those issues resolved, that's got some very positive impacts to us, additionally on cost control efforts. With that, we'd be glad to address the questions you might have.

Operator (participant)

Thank you. If you'd like to ask a question, simply press star, then the number one on your telephone keypad. If you'd like to retry your question, press the pound key. As previously highlighted, please limit your questions to two. There'll be a brief pause while we will compile the Q&A roster. Your first question comes from the line of Tom Wadewitz from JPMorgan. Your line is now open.

Tom Wadewitz (Equity Research Analyst)

Yeah. Good morning. And, congratulations on the strong results and the good outlook. Wanted to see if you could give a little commentary around the target, I guess, the 65% OR target. You had alluded to that in the third-quarter Q&A session that you thought you would, you know, maybe be at 65% or a little better in 2014. And you're sticking with that, but now you've got a swing of, you know, CAD 95 million or roughly year-over-year in pension. I'm guessing on third quarter, you didn't have quite the same visibility to how helpful that swing would be. So what are maybe some of the puts and takes around that 65%? And do you think that maybe that's conservative given the pension tailwind that you have?

Hunter Harrison (CEO)

Yeah, Tom. I think, you know, if you looked at the release, it actually says that 65 or lower. Do I expect to do better than 65? Yes. What's the probability of it? We could debate that. But, you know, if somebody said, "Look, I think you're gonna do 63," I wouldn't argue with that a whole lot. But at the same time, as I've described earlier, we've still got some issues out there. I don't know how bad this winter's gonna be. I know if this first quarter continues like it is, and I hope it's not, we're gonna have some catch-up to do in the next three quarters. So I guess the best thing I can say to you is, as Keith described, all the operating metrics have fallen in place.

We have one significant labor contract to resolve this year that expires year-end with the Teamsters for the running trades here in Canada. I can tell you that we're in some informal negotiations with the running trades in the U.S. And it's hard for me to put a probability on maybe we can make some breakthroughs there. So you know, if you characterize the guidance as conservative, I wouldn't debate that. I mean, if we go back two years, people said we couldn't get there. And now we're conservative. So in the future, sometime we're gonna get this right. We'll get this balanced up.

Tom Wadewitz (Equity Research Analyst)

Okay. Great. Then the second question, I guess either for you, Hunter, or for Keith, can you maybe run through the timing of some of the bigger initiatives or what's gonna have a bigger impact on the operating improvement? I know, Keith, you mentioned that you had some sidings that came on pretty late in 2013. You've got some that are maybe pulled forward in 2014. You know, maybe how big that is in terms of driving operating improvement and cost side and then maybe some of the other big drivers. I'm sure there are a lot, but if you could highlight a couple of the biggest ones and maybe the timing when they really have an effect, that'd be helpful. Thank you.

Keith Creel (President and COO)

Just short answer to that question. I would say that, you know, the things, the capital investments we made in the network last year that we got on late in the year, of course, that's gonna have a meaningful impact in our ability to get to that mid-60 number. So we'll start converting that immediately after weather. I mean, that's the challenge, Tom. When it's 40 below zero, it's hard to run long trains. And long trains are what you build a network for. So once we get out of some of these challenges, Mother Nature's given us, you'll start to see us make hay. Now, will we have quantum leaps like we had last year versus the previous?

I would suggest no, but still steady, consistent gains on train length and train weight and taking out additional crew starts will help us on the headcount issue and help us on the productivity and help us convert that revenue opportunity that's out there, especially on the bulk side. Then the other things we're gonna do to invest money. I mean, the real gains from that are that. Well, they'll come second half. And they'll come in pieces. They're not gonna be any big, again, quantum leaps, but steady, slow progress by keeping helping us drive improvements on the metrics and, and sustaining the story toward that mid-60s number.

Hunter Harrison (CEO)

Tom, I guess the one thing I would add to that is that, and I know it's difficult for you to, for this audience to put it in your model, but a lot of what we're seeing right now is we're going through learning curves here. We're going through cultural shock and cultural change. If I look around this table of the senior team that effectively reports to me, you know, all of us effectively, with the exception of Jane and Peter Edwards, all of us have been here less than two years. In Bart's case, 18 days. So we're gonna gain a lot more knowledge. As we gain that knowledge, we're gonna be able to impact change more out with the operating officers in the field. And so there's a lot of runway left here, going forward. But I think that's a big one that gets overlooked.

I happen to think that the real success of businesses are the people. This team's getting, as I said earlier, better and better, stronger and stronger. I expect that we will be. This is just a little internal goal of ours. I think by the year-end, we'll be out in the lead as far as efficiencies from a OR or low-cost carrier or however you wanna describe it. So there's a lot of runway left here, barring any issues that we can't predict.

Tom Wadewitz (Equity Research Analyst)

Great. Thank you for the time.

Hunter Harrison (CEO)

Okay, Tom. Thank you.

Operator (participant)

Your next question comes from line of Fadi Chamoun from BMO Capital Markets. Your line is now open.

Fadi Chamoun (Managing Director and Senior Equity Research Analyst)

Good morning. Congratulations on the good results and the outlook. Hunter, you've said in the past, consistently that once you have better service, you get a shot at more volume. And now that you've had sort of some time to go to market with improved service, can you share with us a little bit about some of the opportunities you see out there in some of the segments and how quickly you think you can convert that service into growth in the next couple of years?

Hunter Harrison (CEO)

Yeah. I think there's several things there, Fadi. I, you know, number one, as I've talked about before, I mean, you know, people are resistant to change, number one. So you really gotta differentiate yourself from the competition and give people a real reason to make a change. And I think we're in pretty solid ground with our bulk book of business. That's all about efficiencies. And the more efficient we get, the more we can haul of it. But our real focus and so we're gonna focus on being very efficient with bulk. But the real opportunities that I see are domestic intermodal. And the non-bulk business are what we refer to as merchandise.

You know, in my previous experiences, you know, you gotta go out there and prove yourself in the marketplace for, you know, a year and a half or two years before you start to really gain momentum with some of those changes. So I think we'll see some of that kicking in in, in 2014. But I think, you know, out years of 2015 and 2016, we'll really see, about the ability. Now, some of that is restricted to some degree because, you know, people have contracts. And I think we're gonna be probably in the areas that I just described of the domestic and merchandise, we'll be moving away from anything of what might be described as a longer-term contract. I mean, anything number one, I don't know that we'll do that many contracts. But if the customer wants to do a year contract, that's fine.

I think the opportunities are still there. I think to some degree, we're all gonna be meeting in I think it's next week with a.

Fadi Chamoun (Managing Director and Senior Equity Research Analyst)

Monday.

Hunter Harrison (CEO)

New sales meeting where I the easiest way I could describe this is a little bit of a shift away from a marketing-driven organization to a sales-driven organization where we hope we're gonna go to commission sales for that book of business I've described of the domestic intermodal and merchandise. To my knowledge, no railroad has ever done that, really. So we're gonna give people opportunities to go out and sell, you know, in real successful organizations. And the people that make the most money are the salespeople if you give them a product to sell. So all those things being said, you know, I think that this is not just a cost takeout story.

Fadi Chamoun (Managing Director and Senior Equity Research Analyst)

Okay. Just to be clear, these new services, particularly on the intermodal side, have you seen market share improvement as a result of these services directly yet?

Or you're basically saying that this is early stage still?

Hunter Harrison (CEO)

Well, probably all of the above. We've seen some market share shift, particularly domestically. And we've focused on that. That is much better margins. You know, I think the international is gonna be pretty soft this year for the industry. The margins are not as good. And there's gonna be more pressures on it given there's issues in China and Asia. But I think also that we're going through a period where some big names are putting us through what they call a trial period. And, you know, Keith has spent a lot of time hands-on with that, he and Jane and Mark. So I think we're seeing the opportunity if we can produce and do what we say we're gonna do, that we're gonna see gains there rather quickly. Now, we're not gonna go out there and buy business.

You know, it's gonna be quality revenue and people that want quality service and are willing to pay a fair price for it. That's what we're gonna go after.

Fadi Chamoun (Managing Director and Senior Equity Research Analyst)

Okay. That's helpful. Maybe one on the top line also for Jane. So you said 6%-7% this year. You seem to be sort of confident with this outlook. Can you share sort of where do you see the opportunities to do better than that coming from in terms of sector-specific? And also if there's sort of areas of risk in that outlook, where do you feel that the biggest opportunities and the biggest risk are gonna be like in the next 12 months?

Jane O'Hagan (EVP and CMO)

Well, I think that, you know, Fadi, the obviously, the fundamentals that we have in bulk with a record Canadian crop and the fact that potash is back and that we expect that, you know, with the depressed pricing, that this is going to drive sales is a key part. But I think to Hunter's point, you know, we're also using service to drive growth in our bulk book and, you know, driving greenfield development as we've done in grain and as we've done in potash. I think in merchandise, obviously, we are ramping up our frac sand. We've seen that impact come into Q4. We're online with our expansions in crude. But at the same time, I'd say that, you know, we're not going to be going as quickly.

I think that, you know, to Hunter's point, there's lots of things that we need to watch in that marketplace, you know, around risk, around cars. And so we're going to be choosing those opportunities. We feel we've got a good line of sight to our guidance but choosing those that create good, sustained, profitable return. And I think that, you know, the other thing, you know, to add to Hunter's point about our sales force, we've also added a regional component to our sales plan. And I think that's going to give us the additional coverage that we need to continue to build that merchandise side. So with the economy at this point in time and our line of sight to our initiatives, our new sales organization, you know, focusing on selling, and getting at that, profitable growth, our challenge is to go as hard as we can.

So we feel that, you know, we have pretty good visibility to where we need to go with that guidance.

Fadi Chamoun (Managing Director and Senior Equity Research Analyst)

Okay. That's helpful. Thank you.

Hunter Harrison (CEO)

Let me add something before we go to the next question. I made a mistake a while ago. I was trying to be humorous. I've already gotten a couple of calls that some people have misunderstood my comments. My plans are not changing about when I'm gonna leave the organization. The plan is, as we've always said, that sometime in the 2016 time frame, and not locked into that number, but that I would, that would be probably when we would look at the exit strategy of me leaving and, and Keith taking over. So don't, don't misinterpret my enthusiasm earlier that I'm walking out tomorrow because I've got all I need. That's not the case. So I'm gonna be here for a while. Next question.

Operator (participant)

Your next question comes from line of Bill Greene from Morgan Stanley. Please go ahead.

Bill Greene (Managing Director and Senior Transportation Analyst)

Hey. Thanks for taking the question. You know, Hunter, something that you touched on in some of your remarks is just as it relates to labor. I'm wondering if you can offer a little bit of a framework in terms of what's the scope for change there? Can we see something like you achieved at Illinois Central? Is that not even up for discussion? What sort of opportunities do we have to kinda have another step change function and productivity there?

Hunter Harrison (CEO)

Well, I mean, first of all, I think that we're talking with the organizations in the U.S. and it's no secret. And I think they have, I think it's fair to say that they approached us. And we're interested. We've entered a dialogue with them very similar to the type of agreements that most of you have been aware of in the past that we've made a breakthrough at Illinois Central. Now, you know, keep in mind that the U.S. is a much smaller portion of our operation. So to the degree that it, let's just say if we hit that, then we could get an improvement of maybe 30%-35% on the U.S. T&E front. Now, is that a big breakthrough? Yes.

I think maybe bigger even, Bill, is that, you know, we've already started to try an attempt to enter a dialogue right now for the negotiations that end year-end because, you know, it's, it's like we wait till midnight, the last day, till anybody really gets down to business. So we wanna avoid disruption. We wanna avoid anxiety on the employees' part, on shippers' part. So one of the things that we're doing and Keith is leading this effort. He might wanna add to these comments. But is we're trying to enter a dialogue with the employees and talk to the employees, tell them what we're trying to accomplish, why we're trying to do it, what we'd like to be able to do, what do they want, what they would and so we're trying to do this in a refreshing, different way than a typical rail contract.

So, Keith, if you've got.

Keith Creel (President and COO)

Yeah. I would just I would just add to that that it's more of a grassroots type approach. We're certainly trying to engage the senior leadership of our running trade unions in conversations ahead of time prior to negotiations, normally opening, which would be toward the end of the year. At the same time, we're gonna do a very good job of getting out on the ground with our employees, with their members, explaining what's important to us and digesting and taking back in two-way communication what's important to them. The idea that if they understand what we need and we understand what they need, there's, there's a happy medium to be made. We're gonna be focused on that. I've got some cautious optimism. I think it's important that we do understand our employees. Our employees understand us.

Hopefully, a more favorable agreement will come out of it. If nothing else, a more positive morale environment will come out of it.

Bill Greene (Managing Director and Senior Transportation Analyst)

Okay. That makes sense. That's helpful. Thank you. Hunter, I also have a follow-up on something else you said before. So, you know, we'll see where the OR ends up in 2014. But I think everybody would acknowledge that the pace of change has been just breathtaking. So when you think about achieving ultimately, whenever that happens, whether it's 2014 or early 2015, sort of industry-leading OR and cost structure, what's sort of the next ramp for the organization from there? Is it just more OR? Or do you really just have to start driving the growth using that low cost structure to drive the revenue to industry-leading growth rates as well? How do you think about that shift from once you've sort of achieved that goal?

Hunter Harrison (CEO)

Well, as I've said many times over my career, I mean, the objective is not to get to 58, you know, in a high-fixed cost, capital-intensive business. You know, if somebody comes in here with $2 billion worth of business but the OR is gonna be 66, I'm sure they're not gonna turn that down. So we're gonna, in a mature way, try to develop what we call controlled, sustainable, profitable growth, and grow the business appropriately but at the same time, be as conscious as cost-conscious and as aggressive as we've always been. And if we're successful, which I have every reason to believe we will be, in converting the service and going to the market, then we'll be rewarded with that growth. And that, you know, could even open up other opportunities for us.

Bill Greene (Managing Director and Senior Transportation Analyst)

Okay. That's great. Thank you so much for the time and insights.

Operator (participant)

Your next question comes from the line of Keith Schoonmaker from Morningstar. Please go ahead.

Keith Schoonmaker (Director of Equity Research)

Yeah. Thanks. Continuing on right-sizing but maybe switching to assets. Could you update us on your thoughts on magnitude and timing of the CAD 2 billion or so of the real estate portfolio you now may consider as superfluous?

Hunter Harrison (CEO)

Keith, I think that, you know, we're working very hard on the approach we should take there and the right model. My guidance would be that I don't think we will see significant movement in 2014 with that $2 billion that we've described or in that kind of range. You know, I do think there will be some opportunities for a little line sale here or there. But I think it'll probably be at least into 2015 and maybe 2016 gaining full momentum until we convert that and monetize those assets.

Keith Schoonmaker (Director of Equity Research)

I guess, Hunter, Nadeem mentioned a preference for a strategic question. So let me ask a big one. Do you think more mergers will take place in North America? And what would it take for this to happen?

Hunter Harrison (CEO)

Well, let me qualify by saying I'm probably on an island by myself when I give this answer. I do think there'll be consolidations in the future. I don't, you know, I'm not suggesting it's gonna be in the next two or three years. But I do think given capacity issues, pinch points, environmental concerns, you're not gonna build any more railroads. That really, if you look at the U.S., for an example, it's split up east and west. You've got two in the east. And you've got two in the west. And a merger across the Mississippi River is not gonna impact the competitive environment. I think there's a model that, that if presented appropriately, would suggest to the shippers that they could get there could be more efficiencies that way. They could have lower costs. The carriers could do better.

If mergers were allowed, I think there's a model that we had that said, you know, if somebody thinks they're captive and they don't think that we're giving them the right service or the right price, then you'd have to allow Brand X to come in to provide that. So I do think there'll be consolidations in the future and, you know, to try to talk about the timing. But I think in the, I don't think we'll go another five or six years without some consolidation.

Keith Schoonmaker (Director of Equity Research)

Okay. Thank you.

Operator (participant)

Your next question comes from the line of Benoit Poirier from Desjardins Securities. Please go ahead.

Benoit Poirier (Managing Director and Senior Equity Research Analyst)

Yes. Thank you very much. And congratulations again for the very good quarter. Keith, maybe the question is for you. You previously expected our RTM kind of in the mid-single digits for Q1. Obviously, it is going through a rough start. What is your expectation right now for Q1? And is the softness only due to weather issues?

Keith Creel (President and COO)

Yeah. Hello, Benoit. Absolutely, the softness is 100% due to weather. It's not because of opportunity. It's because of the challenges, and I'm gonna be optimistic on this. I, you know, we've got some catch-up to Hunter's point. I don't expect that January and February. February's like January. Then we're gonna have a pretty challenging March to do it. But I'm very confident in this team's ability to deliver that single-digit RTM growth, mid-single-digit RTM growth. So unless March is similar to January and February, we've got an opportunity in March to play catch-up. And I think we're gonna finish strong.

Benoit Poirier (Managing Director and Senior Equity Research Analyst)

Okay. Very good. And would it be possible guys? My second question is related to crude by rail. Just to provide an update on the guidance. I think the latest one was either to double or triple the number of carloads from a base of 70,000 by the end of 2015. And obviously, we've heard very positive comments from NSC, KCS with respect to the heavy oil. So, I just wanna know where it's going on your side.

Jane O'Hagan (EVP and CMO)

Yeah. I think that if we talk about crude by rail, as I indicated, we moved 90,000 carloads. Our guidance was for 140,000-210,000 by the end of 2015. At this point, we don't see a reason to revise our guidance. But there really are a lot of factors, as I said, that can impact us along the way. We continue to watch those factors that could influence the development and the pace of that business, including pipelines, including the impact on tank cars, infrastructure at, you know, origin, at destination. But the expansions that we have line of sight to that we've announced are going as planned. So we feel confident. But, you know, again, I just wanna put it in context that, you know, crude is about 4% of our books.

So again, you know, it's an important thing for us to just watch all the risks.

Benoit Poirier (Managing Director and Senior Equity Research Analyst)

Okay. And I know that you're not happy from a pricing standpoint. So should we expect better profitability as you ramp up volume and you negotiate better contracts?

Jane O'Hagan (EVP and CMO)

Absolutely. I think that, you know, we're gonna be making, you know, looking for all opportunities to obviously upgrade the quality of the book but also looking for ways to incent and ensure that in the crude product, that we're, incenting the use of safer cars and newer cars as well in that process.

Benoit Poirier (Managing Director and Senior Equity Research Analyst)

Okay. Perfect. Thanks for the time.

Hunter Harrison (CEO)

Thanks, Benoit Poirier.

Operator (participant)

Your next question comes from line of Ken Hoexter from Bank of America. Please go ahead.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

Great. Good morning. Thanks for the comments and insights so far. But, Keith, can you talk a bit about you mentioned the sidings, and you talked a bit about CapEx. Maybe some thoughts on future CapEx. Are you looking for more growth investments? Is there still any catch-up in terms of the way some of the network was structured? Any thoughts on the capital spending side?

Keith Creel (President and COO)

Well, I would say catch-up. Maybe not the same challenges that we had in 2013 and 2014. It's more about optimizing the network. It's more about strategic investments in sidings, where we're not congested but we're pushing up against opportunities to actually run longer trains, more longer trains, and take out train starts. So that's pretty much what the game plan is. As far as quantum of capital, I don't see much of a change. It's gonna stay in the range of where it's at now on a go-forward basis. Maybe a little bit of uptick somewhere between one, 1.2, 1.3, two to four. I mean, it's the range. Nothing, nothing huge or no big opportunities or things that's gonna be driving that. We're gonna be focused on CTC on the capital investment side.

Operation-wise, we're gonna focus on siding investments and some tweaks to some of the yards, finishing out multi-year plans. Some money we're gonna spend in St. Paul, as well as a little bit in Chicago. And it's all just incremental investment. It's not anything that's monumental.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

Wonderful. And then.

Hunter Harrison (CEO)

The biggest call on capital right now, and I think that will continue for the next year or two, is that we have a few weak lengths in the network that we're gonna get the basic physical plant in totality where it ought to be. And so rail ties and ballast investment, which, you know, worst case is you buy it a little early. That's gonna be the focus. You know, we're gonna have a kind of a recess here with needs on the mechanical side and with the acceptance of these few other projects like SAP a little. And then Keith mentioned the siding extensions and those things. That pretty well represents where we'll be capitalized going forward.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

Great. Thanks. And just a follow-up, I guess, on Jane, on two of the commodities. On grain, just in down last quarter and just understanding with the record crop, how do you see the building? And similarly on intermodal, just given the lost business you mentioned and your focus on a domestic push, can you any concept on profitability of that shift from the international more toward a domestic push and what that does in terms of shifting lanes?

Jane O'Hagan (EVP and CMO)

Well, I think that, you know, let me attack the grain first. I think that, you know, when we look at the focus of this organization and what we've been doing, you know, this record crop presents us lots of opportunities to basically move grain more efficiently. You know, what we're doing out there is we're obviously offering as many multiple destinations as we possibly can. We had run a very robust program to Thunder Bay. And we're continuing to create diversity, you know, for our grain shippers, across the entire franchise. I think that, you know, what we've demonstrated in last year is that we can be nimble in making those markets because last year, the impact that we had with our drought situation was we moved a lot of grain to markets that we didn't traditionally move.

So I think when I look at the outlook, I think that, you know, we're gonna move grain more consistently. I think this is gonna be one of the crop years where we don't have the peakiness that we've had in the past. We'll probably have some large carryover. And with an average crop, we're gonna see strong movements of grain throughout the entire year.

Speaker 24

Some comments.

Jane O'Hagan (EVP and CMO)

I think as we talk about intermodal, you know, as we look at the intermodal business and we think about the margins, you know, we've been clear before that domestic has a much better place for us in this business. The beauty of the service that we're providing is our operations team has created something for us that is really second to none in the industry. And what this is doing as these contracts open up and as these opportunities open up in place, it gives us the ability to go in and price for that value, knowing that that service is something that no one else can touch. So again, that's part of the strategy for 2014.

Ken Hoexter (Managing Director and Senior Equity Research Analyst)

Great. Thank you.

Operator (participant)

Your next question comes from the line of Steve Hansen from Raymond James. Please go ahead.

Steve Hansen (Managing Director and Senior Equity Research Analyst)

Oh, yes. Good morning, everyone. Just a follow-on question to the crude by rail question asked earlier. I was just curious whether or not you could give us a sense or an indication for whether there's any other large crude by rail terminals being contemplated here in Canada. There's obviously been some large announcements over the past two or three months that changed the outlook quite dramatically. And there's been a lot of suggestions there might be more coming. I'm just wondering whether or not you can confirm or not you've been discussing the concepts with some of the majors in Canada here on the E&P side.

Jane O'Hagan (EVP and CMO)

Steve, just to give you some color on that, as you know, you know, the pace at which this developed with the lights in the Bakken was much, much faster. As we look to develop the terminals in Canada, clearly, we're dealing with producers. We're dealing with refiners. So I can indicate that there is interest, largely within on our network. But again, because this business is competitive, you know, what I encourage you to do is to watch our carloads. You know, the format that we've used in the past is to continue to work with those players that are investing in their cars, investing in their terminals, investing for the long term. So I would just tell you to stay tuned.

Steve Hansen (Managing Director and Senior Equity Research Analyst)

Okay. Fair enough. And just a follow-on question to the previous grain question as well. Can you help us understand what the pinch points might be in the system to move some of this grain that's still lying across the prairies? Again, monster crop. Much of it's still stranded in the prairies. The expected carryover is also gonna be at mammoth levels. I think it's gonna reach, you know, the carryover would be bigger than the last since 1979. So I'm just trying to understand as we move through the non-traditional grain-moving pattern, how the limitations might shape up. Is it carloads? Is it port capacity? Is it locomotives? Where are the pinch points in the system to move the grain?

Keith Creel (President and COO)

Well, I'd say right now, the immediate answer to that, the largest pinch point is weather. That's certainly impeding the supply chain's ability to run as efficiently as we were before. Locomotives and cars, if you don't have weather right, you can't optimize that. Then you're gonna be bumping up against port capacity. You gotta match elevator capacity to railroad capacity to port capacity. I mean, that's it. You can only ship as much as you can load up onto a ship. I know the ports have spent money, invested time and effort. They're working as partners in the supply chain to increase their capacity. And as we do that, with weather on our side, you'll see us matching railway capacity, locomotive, and car capacity against that port capacity.

Steve Hansen (Managing Director and Senior Equity Research Analyst)

Very good. Much appreciated. Congrats on a good quarter.

Hunter Harrison (CEO)

Thanks, Steve.

Operator (participant)

Your next question comes from the line of Allison Landry from Credit Suisse. Please go ahead.

Allison Landry (Senior Transportation Research Analyst)

Good morning. Thanks for taking my question. On the pension side, so given your comments that CP is no longer in a pension deficit position, I was wondering if you could give us an update on the cash contributions that you'd previously outlined, which I believe were in a range of CAD 100 million to about CAD 125 million for 2014 and 2015 and then, stepping up, from that in 2016. Did they go to the zero from here or are they significantly reduced? You know, how do we think about that?

Hunter Harrison (CEO)

Allison, feel free. We can follow up with us after the call if you'd like. But overall, I would say nothing changes at this point. We'll continue at. You have to look at it over a three-year basis. So at this point, we would continue with the contribution.

Allison Landry (Senior Transportation Research Analyst)

Okay. And, in terms of cash flow, free cash flow conversion tripled, basically, to just over 50% in 2013. And as we think about continued margin improvement and sort of flattish CapEx, it seems that this number could easily rise to north of 70% in 2014. And I was wondering if that's a fair way to think about it. And you know, what does that imply for the magnitude of a potential buyback or dividend hike?

Bart Demosky (EVP and CFO)

Yeah. Allison, it's Bart here. So, we don't guide on cash flow. But, you know, one of the things I could tell you is, looking at some of the analyst reports that are out there, they're kind of calling for that $1 billion-$1.1 billion range of cash flow for us in 2014. That's before dividends in 2014. I wouldn't argue with that very much. When it comes to dividend growth or buybacks, you know, we're factoring in the future improvement of the business, the margin growth, and the better operations when we look at our future cash flow projections. That'll be part of the input into what I'll be talking about with Hunter and Keith and the board here on shareholder. And it'll impact our decision-making around how we utilize some of that excess cash.

But I can't tell you today exactly what that's gonna look like.

Allison Landry (Senior Transportation Research Analyst)

Right. That makes sense. Okay. Thank you very much for the time.

Operator (participant)

Your next question comes from the line of Chris Wetherbee from Citi. Please go ahead.

Chris Wetherbee (Senior Transportation Research Analyst)

Very thanks. Good morning. You know, Coach and Keith, you mentioned sort of where you stand relative to fuel efficiency and the progress you've made so far. When you think about sort of train length and weight, where do you feel like you are in the process? And how much more do you think you can improve? Sort of what inning are we on, on those two metrics specifically?

Keith Creel (President and COO)

You know what? I think there's probably, when we get all these sidings done and this is gonna take a couple years to get it done, but there's still another 10% or 15% improvement on both those measures to be driven by converting DP and long sidings and longer train.

Chris Wetherbee (Senior Transportation Research Analyst)

Okay. That's helpful. And then, Hunter, just when you think about some of the longer-term targets that you guys laid out back in December of 2012, you know, clearly closing in on that in a much earlier pace, do you give us sort of newer, new updated targets at some point in 2014? Do we just sort of think about sort of the lower end of your previous OR range? I just wanna put some context around how we should be thinking about sort of the longer-term opportunity beyond 2014 and into 2015, 2016, and beyond.

Hunter Harrison (CEO)

Well, right. You know, we're very sensitive to what you're saying in that we've run over this plan. So I think the plan's right now and somebody can correct me here if I get out of line. But we plan on having an analyst meeting in September of this year, in the New York area, I think. And my sense is that we will develop at that point a new plan and probably come out with a five-year plan which updates everything and makes it easier for you to look at the future.

Chris Wetherbee (Senior Transportation Research Analyst)

Okay. So we should be looking for that in the third quarter. That's helpful. I appreciate it. Thanks very much.

Hunter Harrison (CEO)

Sure.

Operator (participant)

Your next question comes from the line of Brandon Oglenski from Barclays. Your line is now open.

Brandon Oglenski (Director and Senior Equity Research Analyst)

Yeah. Good morning, everyone. Congrats on the solid 2013 outcome. Keith, I wanted to follow up with you on the volatility in the business inherent with winter. You know, obviously, you had some challenges in December. It looks like you guys have a little bit more robust operating plan that allowed you to have a pretty good outcome even with those challenges. As we look forward, should we look for less earnings volatility in the fourth and first quarter? What are some of the steps you're doing to mitigate those impacts?

Keith Creel (President and COO)

Well, I mean, when it comes to winter, the impact essentially is train length. That's what really hurts you or that's what your headwind is, so to speak. So you just gotta try to railroad smarter. You can't push the envelope. You gotta make sure you optimize the use of the DP. You got the right configuration. You got the right distance between the locomotives. You got the right blocking and tackling going on in the terminals. And I'm not gonna suggest we're perfect. We're far from perfect. And I see mistakes. And we learn from mistakes on a daily basis. But we are getting better. We're trying to mitigate the impact. And part of the other key to this is not flooding the network with cars and locomotives that you can't move 'cause it's, you know, it goes to the analogy.

You, you think more is better, but actually, less is better when you get to these kinda situations because if you've got more equipment out there that you're trying to move and you're trying to force and you've got more than you can really, effectively process through your terminals on your main line with these challenges, you're just gonna drag the whole network down and mess everything up. So that's the focus. It's all about blocking and tackling. And that's how you mitigate or minimize the impact of the bottom line.

Brandon Oglenski (Director and Senior Equity Research Analyst)

Well, appreciate that. Bart, I know you're new on the job here. Looking at the leverage profile of the company and, you know, given the changes in FX rates and interest rates right now, how do you think about, you know, the credit profile of CP and what you'd like to do with the balance sheet from a debt perspective?

Bart Demosky (EVP and CFO)

Yeah. Sure, Brian. I'm actually in the middle of looking at all that right now. What I'd say from the early indications are that clearly, the quality of the balance sheet is better than the current ratings of the company. So, I just talked with all of the rating agencies yesterday to get a sense of, you know, what their needs are and sort of timing around when their reviews would be. But I suspect it's quite positive. Leverage targets are something else that we're looking at. But, and so I can't give you full details. I think, as we come through this quarter, I'm gonna get those plans in place and be able to start talking about it more fully.

But as the operations continue to improve and we pay down debt, and we have just recently bought out a long-term capital lease as an example of debt paydown, we may have opportunities to manage leverage, whether that be a debt issuance and taking advantage of the current low rates or doing something else. But it'll be in conjunction with the whole operations and business plan rather than, you know, something that's unique or off on its own.

Brandon Oglenski (Director and Senior Equity Research Analyst)

All right. Well, appreciate it. We'll look for more to come.

Hunter Harrison (CEO)

Okay. Thank you.

Operator (participant)

Your next question comes from line of Scott Group from Wolfe Research. Please go ahead.

Scott Group (Managing Director and Senior Analyst)

Hey. Thanks. Morning, guys. So, someone asked earlier about better service leading to market share. And I wanna ask you about better service leading to better pricing. And wondering if that's something that's starting to happen. So I think, Jane, you mentioned that renewals came in above the 3%-4% target, which I think is a change. And wondering if we're kind of finally at that catch-up point where we can start seeing some better pricing. So just some thoughts along there would be great.

Jane O'Hagan (EVP and CMO)

Scott, I think what I would start off by saying is that, you know, given what Hunter said about change in culture, you know, the last year, we spent time just ripping apart our book of business and addressing the quality of revenue. You know, we made some tough choices. But again, you know, this is a journey. You know, it doesn't happen overnight for us. I think that, you know, we're never gonna be finished because this is something that we're gonna be looking at as the quality of service improves and as that service drives us to be able to offer different products to different customers. You know, we've upgraded accounts. We've upgraded lanes that needed to be addressed.

You know, to Hunter's point, we have transformed many of our pricing mechanisms to move ourselves away from contracts and to get to tariff where we can give ourselves some more flexibility to go after all the various components of price. And I think the other thing that we've taken a really strong effort at in pricing is that there's all the other components that go in as well around supplementals and demurrage. And we've been standardizing that and forcing those terms. So, you know, when you couple that with the approach that we have to get people out selling service and not price, backstopping what we've done with higher renewals above our 3%-4%, we feel we're on the journey, but we're never gonna be done.

Scott Group (Managing Director and Senior Analyst)

Do you feel like you're in some ways priced at a discount right now? I mean, should we be expecting that the renewals to kinda stay above this 3%-4% range? Or are you sticking with 3%-4% as the realistic target?

Jane O'Hagan (EVP and CMO)

At this point, I think what we do is stay with the 3%-4%. I mean, obviously, what we need to do each and every time is understand how the business offering that the ops team has set the table for us with commanding value in that customer's supply chain and extract that value accordingly. So I think that, you know, as Hunter indicated, you know, this is not something that you accomplish overnight. But it's something that, you know, we've had renewed our focus. We've done a tremendous amount of work over the last year. And we're gonna keep pushing on the same front.

Hunter Harrison (CEO)

Let me just give you an example. This is what fits with our strategy. I mean, you know, as we lower our cost - excuse me - and if our price, let's just say, stays at 3% or 4%, the margins continue to improve. We can't turn that kinda business down. But at the same time, we're gonna extract the value out of it. That's one of the reasons that we're more domestic-oriented from an intermodal standpoint. Number one, the price for domestic is significantly better than international, number one. And it's also lower cost. So we don't have to build big facilities. You don't see domestic trailers or containers sitting in hubs for six, seven, and eight days. So, you know, that's an international scheme. And domestic, wanna turn them over quickly, turn the asset, move it.

And that's a high-quality customer. And it's a different style customer that happens to fit with us. So, you know, we're gonna try to hopefully play to our strengths. Now, I'd like to do everything we can internationally. But right now, it just doesn't fit given where the market is.

Scott Group (Managing Director and Senior Analyst)

That makes sense. And just one other for you, Hunter. Just what's your latest thoughts on where the headcount can grow from here? And how much of the purchased services savings that you talked about a year ago do you think you've realized yet and how much more to go?

Hunter Harrison (CEO)

On a growth basis, I mean, I think we're probably on that purchased service, we're probably 60% of where we can be. You know, the headcount issue you know, and, and I, I don't like that term. And I'm you know, I, I don't wanna lock us in to a number that says we're not gonna make a bad business decision to get to some number. But having said that, everything in, if things play out going forward as we think they will, without tremendous growth, the number can and as I've talked about before, can approach a 6,000. Now, and, and once again, we're positioned there, to be able to handle that, probably 85% or 90% through attrition. You know, we had a lot of people, I think, around the organization that were waiting for buyouts. Well, I don't, I'm not a buyoutter, okay?

So some people learned that they were waiting for something that wasn't gonna come. So they've decided to move on. So we're gonna get this organization right-sized. We still have productivity gains to be made, just to Keith's point a while ago about, you know, 15% with train starts and fewer locomotives and all those things. So there's a lot more runway in every one of these metrics. I don't know of any of them that we've run out of.

Scott Group (Managing Director and Senior Analyst)

Gotcha. Okay. Great. Thanks, guys.

Operator (participant)

Your next question comes from David Newman from Cormark Securities. Please go ahead.

David Newman (Equity Research Analyst)

Good morning. Congratulations on the quarter. Welcome, Bart.

Bart Demosky (EVP and CFO)

Thank you.

David Newman (Equity Research Analyst)

Just looking once again on the pricing side, it would seem to me by segment that the biggest opportunity would be in the domestic intermodal mixed merchandise. And, you know, given what's going on on the trucking side of the regulations and hours of service rules, etc., is that gonna be the area with the biggest bang for the buck, I guess, on pricing? And if you look at the bulk side, getting down to annual contracts, there's likely to be more flexibility on the pricing overall. So I guess if you look at segment by segment, where do you think the pricing could be the most meaningful?

Jane O'Hagan (EVP and CMO)

Well, I think to the point that Hunter made previously, I think that when you look at the merchandise sector and you look at the domestic intermodal, you know, the margins are there. You know, there's truck-competitive business that when you look at the service offering that we put into the marketplace, when we can compete against other rail and we compete against truck, we have an opportunity to tap into that margin. And that's exactly what our strategy is. I think that when you go forward on the merchandise side and you look at over the years, you know, the fact that in some areas, you know, we're not getting our fair share of the wallet of some of our customers. We have the opportunity to sell them a broader range of service. But we do that as that service improves.

I think with grain, you know, there's always a portion of the book of business that's gonna be regulated, which in Canada is about 60%.

Bart Demosky (EVP and CFO)

Right.

Jane O'Hagan (EVP and CMO)

But there's 40% that we have here that is commercial. And our U.S. franchise is commercial as well. I think that one of the things that we've seen post-CWB is an opportunity to see grain moving in different corridors. And we have the opportunity to work with different companies to find ways to get that grain to market and where we can extract some price for that, for that value of service. So, I think overall, again, it's a journey. But I would say that, you know, that would be sort of directionally be correct in those areas.

David Newman (Equity Research Analyst)

And just a quick add-on. So the revenue caps that you have on the grain side, there had been some discussion about potentially removing those. Is that just wishful thinking? Or do you think that could actually happen at some point here?

Jane O'Hagan (EVP and CMO)

I mean, I think that, you know, there was a long time that, none of us who had been in the business ever thought that we would see the single desk selling go away or the monopsony of the CWB.

Bart Demosky (EVP and CFO)

Right.

Jane O'Hagan (EVP and CMO)

I mean, my view would be is that, you know, a fully commercial network, when you look at having a record crop, you start to look at some of the efficiencies you wanna build in. You know, it would make some sense given the fact that grain has becoming a much more global market. But I think at the end of the day, that this is a regulated sector of the business. You know, government will have a key part in determining what that framework would be. But I think that, you know, when we start to see, you know, our ability to respond, there certainly are, given the fact that our U.S. franchise is right across from many of the high-throughput elevators we have in Western Canada, that there could be some benefits to looking at that, certainly. And, we've had some discussions the same.

David Newman (Equity Research Analyst)

And final one. Just the receptivity of your bulk customers to moving towards annual contracts, is that something that they're welcoming as well? It obviously would give you a bit more flexibility on your pricing, I would imagine, as well.

Jane O'Hagan (EVP and CMO)

Well, I think it depends. I think that when you look at, you know, our potash business, you know, we've been pretty clear in, in our coal business that we have long-term contracts that basically, you know, provide escalation that covers us, certainly, to get those, to get the pricing in market. But also the fact that we have productivity that where we spend or we create benefits, we keep that. I think the grain business has always worked on a tariff basis. I think that, you know, some of the opportunities we have on the fully commercial piece to, tune up those tariffs and have them responsive to what the supply-demand is are opportunities for us as well.

David Newman (Equity Research Analyst)

Excellent. Thank you.

Operator (participant)

Your next question comes from a line of Turan Quettawala from Scotiabank. Your line is open.

Turan Quettawala (Director of Transportation and Aerospace Equity Research)

Yes. Hello. Good afternoon. And, my congratulations on the great quarter here. Maybe I'll ask, one, for Bart just on the free cash flow here. Bart, obviously, message understood on not wanting to sit on cash here. But I'm just wondering if you can give us any sense on maybe a balance between buybacks and dividends, especially considering, you know, where the stock is at today. Thank you.

Hunter Harrison (CEO)

Yeah. Good morning. I hate to sound a little bit like a broken record. But it's a bit early to comment on that. We're getting our hands around how much there's going to be. And then we'll have a good discussion internally and make decisions on that. And I have to sit down with Hunter and Keith and the board on it, so.

Yeah. Let me just. You know, it's still unfair to Bart. But, you know, I think I've said to you, and I think, the board is very sensitive to these issues. They're very sensitive to the fact that we have far exceeded the plan, that we're way ahead of schedule. I would think that by at this next call at the end of next quarter, we'll have some pretty definitive responses to what we're gonna do and how. Now, you know, there's some tricky issues here with our ownership shift. For example, right now, when the proxy considered the ownership between the U.S. and Canada was 50/50, now it's about 80/20. Well, people in the U.S. aren't crazy about dividends because of the tax treatment. People in Canada like dividends. So we've gotta take all that and put it to blender.

I feel pretty confident that we're gonna come back to you with something of a positive nature there. How aggressive it is and what size and all that is yet to be determined is Bart's modeling and going through some of that now. But I think it's something that will be positive in the future.

Turan Quettawala (Director of Transportation and Aerospace Equity Research)

That's great. And maybe I can ask one for Keith quickly here just on the weather. Keith, just if you look at the whole network here, is the weather a bigger challenge in January than it was in December? Or was sort of December worse? I know it's not good. But I'm just kinda wondering, oh, you know, on a relative basis. Thank you.

Hunter Harrison (CEO)

I'd say it's equal. I'd say it's about the same. I mean, you know, across the whole network, we're impacted the last two weeks of December. But that's two weeks versus I got four weeks in January. And I've got it across probably two-thirds of the network. I mean, you go down to Chicago. I was in Chicago earlier this week. It's, and I've lived there for seven years. It's never been that cold. Snow all over the place. St. Paul, same story. I mean, we're not short on challenges. But I'm not gonna be long on excuses either. We're gonna execute. And we're gonna make up.

Turan Quettawala (Director of Transportation and Aerospace Equity Research)

Great. Yeah. I know it's minus 30 here today as well. Thank you.

Operator (participant)

Your next question comes from a line of Jeffrey Kauffman from Buckingham Research. Please go ahead.

Jeff Kauffman (Director of Transportation and Logistics Equity Research)

Thank you very much. And again, congratulations, everyone. Keith, can you talk a little bit about where you are on a capacity basis in Vancouver and that port's ability to handle your growth with intermodal or, or wheat or, or potash, and what role CP plays in terms of helping to build that growth?

Bart Demosky (EVP and CFO)

Well, I guess you got a couple different destinations there and a couple different stories. Deltaport, which is TSI, which is where we're intermodal the preponderance of the intermodal's coming in and going out. You know, CP's not the same-sized player as CN. But I can tell you now they have their challenges. And those challenges are compounded by what the shipping companies do. When they're slow-boating across the ocean to save fuel, and they don't hit schedules, and you have five ships that show up on a two-day span that should have been over a five-day span, then you're gonna get bunching. And you're gonna create capacity and take away needed capacity to be fluid. So I would say they're not long on capacity at Deltaport. So some impact there.

If you shift to the inland, if you go up to Vancouver and you talk about potash, Neptune, they've spent some money in Neptune to expand capacity. So potash and coal there, I think, as long as weather cooperates and as long as our partners, we're not the only ones using the facility. They remain fluid. We remain fluid. I think we're okay at capacity. As you go to the grain side for the export terminals, they, too, have spent money and invested. Some of the challenges they're still subject to, wind, rain. They're trying to mitigate that. So from a growth standpoint, I think that they're getting better. I think that, as we get better, we can match up. And we'll consume that capacity.

There's some room to grow on both sides, both for the railways as well as for the farmers as well as the potash shippers and the coal shippers.

Jeff Kauffman (Director of Transportation and Logistics Equity Research)

Okay. Thank you. And Jane, follow-up. Given all the improvements in service, I, I know you don't always play nice in the sandbox. But I was a little surprised to hear about some big contract losses on intermodal and auto. Can you talk a little bit about the competitive environment and with your service product improving, what's the primary reason for, for those customers switching?

Jane O'Hagan (EVP and CMO)

Well, I'd say that, you know, the rail business at the outside is a competitive business. And, you know, we're obviously gonna be pricing at a level, and with that value of the service we provide. And, you know, by and large, I expect, railroads of, you know, others to do the same thing. You know, I think that basically, when we look overall, you know, it could boil down to price. You know, some people are focused on the value. Others are focused on the cost. And, you know, I can't you know, I can't give you a specific example. But I can tell you that, you know, with respect to, the service that we provided to the, the major contracts that we've discussed that we chose not to price to, this was not a service issue. This was a pricing issue.

At the end of the day, we're going to work with those customers that, you know, see the value and where we can earn a fair and reasonable return.

Jeff Kauffman (Director of Transportation and Logistics Equity Research)

Okay. Thank you. Congratulations.

Operator (participant)

Your next question comes from Donald Broughton from Avondale Partners. Please go ahead.

Donald Broughton (Managing Director and Senior Transportation Research Analyst)

Oh, well, congratulations on a good quarter. My questions have been answered. Thank you.

Hunter Harrison (CEO)

Thank you.

Operator (participant)

Your next question comes from Thomas Kim, Goldman Sachs. Please go ahead.

Thomas Kim (Research Analyst)

Thanks. If I could just follow on the comment on price, just given that CN still has an OR advantage, are you beginning to see them use that a little bit more aggressively even outside of intermodal?

Jane O'Hagan (EVP and CMO)

I mean, I can't talk to specific examples. I mean, that's a question you're gonna have to ask CN. I think that, you know, while we have our own game plan, you know, we price for value, we need to look at what we do to increase the operating income in the book and we'll build quality revenue.

Thomas Kim (Research Analyst)

Okay. Then just, with regard to the new incentive scheme for the sales force, now, you know, there seems to be a general tendency for sales to focus on revenue. And, you know, obviously, there can come the sort of risk that they push volumes over freight rates. And I'm just wondering, you know, to what extent the new scheme has measures in place to protect pricing integrity? And, like, for example, do you know, do you incorporate a margin as part of the overall incentive as well? Thanks.

Hunter Harrison (CEO)

Well, the answer is yes. Number one, if the car loads that show a sufficient margin that we have determined, you know, you don't even get counted for it. So the first criteria's got to be profitable at this level, number one. And then, if there's some issues about, it's effectively only new business. It's not business that we've had before. And then if it meets that criteria of profitability and new with some qualification for prevailing conditions, both up and down, windfalls, and so forth, then they will receive a percentage of the profitability of that unit. And, you know, it's a pretty simple method for people to go out and sell price, I mean, sell service under a disciplined environment.

Thomas Kim (Research Analyst)

Okay. That's helpful. Thank you.

Operator (participant)

Your next question comes from Jason Seidl from Cowen and Company. Please go ahead.

Jason Seidl (Managing Director and Senior Equity Research Analyst)

Yeah. Thanks, guys. Well, you know, when I'm looking at sort of your revenue per carload on, on the grain side, I mean, I know there's a lot of moving cars, especially with, you know, what, what, what could go export. Well, what should we be looking for on that line item on a year-over-year basis?

Jane O'Hagan (EVP and CMO)

I think that, you know, it's difficult to predict. And, you know, I'd indicated last quarter that I would have expected that, you know, the revenue per carload would have been impacted by some of the regulated grain because of the fact that, you know, we do work to a Maximum Revenue Entitlement in that segment. But I think the fact that we have two different grain franchises and that there is a commercial component in and that, you know, we've been nimble in the market. We've been providing options, you know, I'd be inclined to think that, you know, we're gonna probably see yields in and around that same area.

Jason Seidl (Managing Director and Senior Equity Research Analyst)

Okay. All right. That's fair enough. And, Hunter, you know, going back to sort of the new sales structure, you know, how's that gonna impact maybe sales and their relationships with operations? Because, you know, sometimes those two sort of bang heads in the past in the rail industry.

Hunter Harrison (CEO)

Well, that's our job. I mean, this is a team. Everybody's got a part to play. The operating guys provide the service. Jane and her team sell the service. And we make a buck. And everybody's happy. And anybody that, you know, can't be a team player, then they've gotta find another team to play on.

Jason Seidl (Managing Director and Senior Equity Research Analyst)

Well, sounds good. Sounds like you guys made a little bit more than the buck, though.

Hunter Harrison (CEO)

Yeah. That's it.

Jason Seidl (Managing Director and Senior Equity Research Analyst)

Take care, guys. Appreciate the time.

Hunter Harrison (CEO)

Thank you.

Operator (participant)

Your next question comes from Walter Spracklin from RBC. Please go ahead.

Walter Spracklin (Managing Director and Senior Equity Research Analyst)

Thanks very much. Thanks for taking my call. Question on the revenue guidance, 6%-7%. I'd like to decompose that a little bit. I think I heard Keith mention mid-single digit RTM growth. And my question, I guess, is to Jane with regards to mix because, you know, hearing you on the renewals coming in above the 3%-4%. And when I look at yield - and this is on a revenue-per-revenue ton-mile basis - just noting that it was 0.9% in the year and 1.8% in the quarter, just curious whether mix is at play here. I know you've got a lot of moving parts with regards to significant increases in grain, some declines in intermodal, and so on.

How should we look at mix playing itself out in 2014 in a kind of an order of magnitude, on a revenue-per-revenue ton-mile basis?

Jane O'Hagan (EVP and CMO)

Well, I think that if you look at Q4, when we talked about mix, you know, we had a lot of moving parts. You know, I've flagged them to the extent that I can over each and every quarter in 2013, you know, to remark on the impact of the long-haul crude volumes, you know, when we have any shift that takes place in the short-haul thermal volumes. I think that the other area that we always have impact given, you know, what we saw over the last year, given the fact that we were in and out of the potash business; these are all things that impact, you know, our cents per RTM.

I think that, you know, when you look at a go-forward basis and, you know, think about that mix, you know, again, what we're gonna see is, you know, if our plans come to fruition, which we fully expect that they will, you know, crude oil's gonna continue to play an important part of the book. That's obviously gonna impact the RTMs given that length of haul. I think that grain, you know, we're seeing that on positive on an R/C basis given all the various outlets we have. So it's really hard to predict. But I think that's where, you know, we're gonna see it, Walter.

Walter Spracklin (Managing Director and Senior Equity Research Analyst)

Okay. And then my second question's on a little bit of a disconnect between operating income implied by your guidance and then the EPS growth. And so if, you know, if I take your revenue growth, that I'd grow it at 7%, put a 65% OR, the EPS growth is somewhere lower. And I'm wondering if you've built in into your estimate any significant change in your capital structure through debt repayment. Is it a U.S. dollar phenomenon where you're paying less U.S. you, you know, the impact of a higher Canadian dollar debt refinancing? Or is there a share buyback at all built into your guidance for 2014?

Hunter Harrison (CEO)

Let me, Walter, I think you have to look at the variability in those numbers. You know, we're saying that the OR is at 65%. But it could be lower. At the same time, you know, we're looking at the revenue. And it could be lower or higher. Well, you fit different numbers in there of the likelihood and the probability. And you can get several different answers on EPS given what value you give to each one of those. But I think they all fit within an appropriate range.

Walter Spracklin (Managing Director and Senior Equity Research Analyst)

Okay. Perhaps I'll follow up with Nadeem on that after the call. Thank you very much. That's all my questions.

Hunter Harrison (CEO)

Thanks a lot.

Operator (participant)

Mr. Harrison, I have no further questions at this time. Please continue.

Hunter Harrison (CEO)

Okay. I'm sorry about the duration. We took too long on the call. We had a lot of questions. I wanted to try to address all of them. We look forward to the next opportunity to visit with you. Hopefully, the weather conditions will be a little better. We'll have even better results. Thanks.

Operator (participant)

This concludes today's conference call. You may now disconnect.