Canadian Pacific Kansas City Ltd. (CP) Q3 2015 Earnings Report, Transcript and Summary

Greeting, and welcome to the Kansas City Southern third quarter earnings call. [Operator Instructions] This presentation includes statements concerning potential future events involving the company, which could materially differ from events that actually occur. The differences could be caused by a number of factors, including those factors identified in the Risk Factors section of the company's Form 10-K for the year ended December 31, 2014, filed with the SEC. The company is not obligated to update any forward-looking statements in this presentation to reflect future events or developments. All reconciliations to GAAP can be found on KCS website, www.kcsouthern.com. It is now my pleasure to introduce your host, David Starling, Chief Executive Officer for Kansas City Southern. Mr. Starling, you may now begin.

Good morning, everyone, and welcome to Kansas City Southern's third quarter 2015 earnings presentation. Joining me for today's call are Pat Ottensmeyer, KCS President; Jeff Songer, Chief Transportation Officer; Brian Hancock, Chief Marketing Officer; Mike Upchurch, Chief Financial Officer. And José Zozaya, our President and Executive Representative of KCSM will be available on the phone for questions from Mexico. We're not blind to the fact that by adding Brian to our speakers list, we've made already pretty full speakers platform even more crowded. But don't worry, we have no intention of making our call this morning any longer. But it is important that you have the opportunity to get to know Brian and start to get a sense of his vision for KCS sales and marketing function. We're extremely happy to have him as a part of our executive team, and I am sure you'll come to appreciate what he brings to the company. In the interest of time, let me quickly turn for a brief overview of the third quarter. KCS revenues for the quarter declined by 7% from a year ago. However, when you exclude foreign exchange and the impact of lower fuel surcharge revenue, the picture looks considerably better, with revenues actually increasing 1% from the third quarter 2014. Excluding impacts of foreign exchange and fuel surcharge revenue probably provides more accurate view of the current health of our business. While even 1% revenue growth isn't where we would like it to be, it illustrates that we have improved from the second quarter and that we're moving in the right direction. KCS adjusted operating ratio for the third quarter came in at 65.2%, a 9 point improvement from last year. And while operating ratio is only one metric we use to evaluate our overall performance, the fact that we achieved margin improvement in the third quarter, despite experiencing a decline in volume, speaks to the strength of the KCS franchise and our ability to shape our operation to conform to business conditions. Even though year-over-year our third quarter carloadings decreased 2% on a sequential basis, carloadings were up 9% over the second quarter. Without a doubt, seasonality plays into this. The third quarter is usually stronger than the second. But this year the 9% rate of growth was more than double what it was last year. This gives us further confidence that KCS's overall business is recovering rapidly. And while two weeks do not make a quarter, the positive trend appears to be continuing in the fourth quarter. Finally, our service improvement steadily improved during the past quarter. And you can expect continued improvement, as we finish out the year. In a few minutes Jeff Songer will provide you with more background on our operations both in Mexico and in the U.S. Now, let me turn it over to Pat.

Thanks, Dave, and good morning, everyone. I'll being my comments on Slide 7 of the presentation. I'm only going to touch on a few key points sort of a current state of the railroad and our view of the environment, in which we're operating. And Jeff Songer and Brian Hancock will provide more color on some of the specific areas that we know will be of a greater interest to the audience today. As you saw earlier, revenues for the quarter were down 7% and a 2% reduction in volumes from 2014. If you recall from the second quarter earnings call back in July, we reported that the third quarter would be up sequentially and less worse than second quarter in terms of year-over-year comp. That's pretty much where we landed. As Dave mentioned, sequentially revenues and volumes were higher than the second quarter of 2015 by about 8% and 9%, respectively. As you'll see on the following slide, volume so far in October continue to improve. And subject to ongoing uncertainty in energy markets, we feel good about the trajectory of demand as we head into the end of 2015. Through the close of business, Wednesday, average daily carloads for October were running about 1% higher than September and 1% higher than October of last year as well. In spite of an improving pricing environment, revenue per unit during the quarter decreased by about 5%, which as you can see on the box in the upper right-hand side of the slide, was driven largely by reduced fuel surcharge revenue and negative foreign exchange impact caused by a deterioration in the peso. In addition, we did take some pricing action during the quarter to improve demand for utility coal, given the low price for natural gas and unused capacity we had on certain parts of our network, which handle the coal volumes. This was done on a short-term basis with no service or capacity commitments, meaning that if demand for other commodities dictates, we can essentially regulate the amount of coal volume we handle under the short-term incentive arrangement to manage our overall revenue and yields. Back to the core pricing environment, we saw continuation of the positive pricing trend that we have been reporting now for the last five quarters, with same-store sales increasing by about 4.1% from last year. The rate increase on contract renewals and extensions that actually took place during the quarter was also 4.1%. In the interest of time, I am just going to touch on a couple of the business units, and Brian will get into more detail on energy, intermodal and automotive in a couple of minutes. Strength in our chemical and petroleum business was driven by higher non-crude petroleum shipments and plastics as well as strong pricing. You can see that FX and fuel had a very powerful impact on revenue in this business unit during the quarter. The weakness in our industrial and consumer business unit was really across the board in terms of commodity type, but the primary driver was metals and scrap. That weakness was driven by the same factors that we cited in the second quarter, which were reduced demand for drilling pipe and continued high level of the imports due to strong U.S. dollar. On the positive side, we saw a better than average pricing increases in our boxcar business, which should bode well for us in future periods. Finally, our ag and mineral business units showed solid growth, driven primarily by grain and food products. Unlike some of the other rails, our export or cross-border grain demand continues to be strong with carloads increasing by about 4% versus last year. Just as a reminder, export grain, primarily to Mexico, in our case, represents about 58% of our total grain volumes and about a-third of our total ag and minerals business. Moving on to Slide 8, we show you daily average carloads back to January of 2014, and you can see the positive momentum that we have experienced here over the last few months. Through October 14 or Wednesday of this week, average daily carloads have increased now for six consecutive months, and so far in October are higher than the previous year for the first time since January. I will also say that this trend is pretty much across our entire portfolio of business with the exception of metals and scrap, where we continue to see weakness for the same reasons that I cited earlier. The key point from this slide is at this moment, business demand still feels very good to us, with the obvious caveat about the uncertainty in energy markets, which you have seen across the entire rail sector, have made it more difficult to forecast demand and provide guidance. For that reason, and just so you know when we get to the Q&A, we are not going to provide any revenue or volume guidance for 2016 on this call today. Brian will cover the outlook for the rest of 2015 in a few minutes. Finally, moving on to Slide 9, I want to just touch briefly on the status of our recent service, resource and capacity issues that we discussed at some length on our second quarter call. Jeff Songer will cover this in greater detail in a moment. But I would like to state that at this moment, we believe we have proper alignment of crews and locomotives on both sides of the border to handle current business volumes. Jeff will take you through recent performance metrics and you'll see noticeable trend line improvement over the last few months. Does this means that our service levels are fully recovered and at exactly the level that we would like them to be? No. We still have crews that are completing training and not fully qualified. In addition, there are segments of our network where growth and demand have been sufficiently strong to require additional track capacity, including the project cited on Slide 9, in order to achieve optimal service levels and equipment cycles. The punch line however is this, we no longer feel that these service issues, particularly crews in Mexico, are going to constrain our volumes and revenues going forward, as they have over the past two quarters. With that, I will turn the presentation over to Jeff.

Thank you, Pat, and good morning, everyone. Beginning with Slide 11, rapidly growing interchange volumes and June and July maintenance curfews in the Kansas City interchange region impacted early quarter performance. Sequential volume at the Kansas City interchange increased roughly 80% in Q3 versus Q2. Putting this in perspective, the 2014 sequential increase for this interchange volume was about 13%. Coal recovery from Q2 levels and the increase in crude oil were the main drivers for this volume. Last quarter I referenced peak furlough of 8% and peak locomotive storage at 12%. In Q3 we restored all north end crews to service and have placed all, but a few locomotives back in service. While we believe the actions to suspend resources in Q2 this year were prudent, given the business outlook at that time, we lost a few crews who did not return to work after furlough and incurred time and expense placing locomotives back into service. Overall, I am pleased with the operational and cost control performance given the large swings in volume we have seen this year. U.S. service rebounded in September as resources were realigned with volumes and October month-to-date velocity in the U.S. is back over 27 miles per hour. Regarding capacity, we have restarted projects in the Kansas City area that were put on hold early in the year. These projects will provide for additional terminal capacity and allow for more efficient mechanical inspections of grain and crude equipment. Turning briefly to cars online, we have experienced a year-over-year increase in our cars online. The majority of this increase is related to tank cars and coal cars to support the energy volumes and grain cars to support that business. Additionally, as our two online origins for grain continue to grow, a greater percentage of our grain fleet remains online versus interchanging with connecting carriers. We will continue to manage other car types according to projected volumes and will look for opportunities to control cost in our intermodal and automotives fleets, while balancing business needs and service levels. Turning to Slide 12, Mexico performance has focused on regaining consistency in our terminals and line-of-road. As Pat mentioned, we have achieved our hiring goal for 2015 and we continue to train and promote yard positions to road engineers and conductors. Dwell has remained stable and should continue to show improvement due early 2016 supported by the first phase of our Sanchez Yard expansion, which is on schedule to open in December. This expansion will not only help Sanchez, but continue to improve terminal operations at Nuevo Laredo and Monterrey. Work will continue at Sanchez in 2016 with the addition of classification tracks and mechanical support facilities. While, we have not yet achieved normal levels in our velocity, we continue to work in those areas most affecting performance. As mentioned, yard crews are training to become road engineers and conductors. This process will continue through Q1 2016. We are also in the process of working with our union on our 2016 hiring plan to ensure we have adequate crews to meet volume demand and attrition. Additional capacity projects due to come online in Q4 with signings in our Central region will help fluidity in that area and we will continue to invest in the areas of Lázaro and line-of-road capacity in the Central and Southern regions. I will now turn the presentation over to our Chief Marketing Officer, Brian Hancock.

Thanks, Jeff, and good morning, everyone. It's a pleasure being part of the KCS organization and I appreciate the opportunity to discuss our third quarter results. To begin, as noted earlier, carloadings were down 2% year-over-year with revenues increasing by 1% when adjusted for fuel and exchange rate impact. Rather than reporting some of the commodity groups that Pat mentioned, I'll concentrate on a few areas for which you probably have been questions. As you can see on Slide 14, our intermodal volumes were down 6% from 2014. The primary reasons were the service interruptions felt by our customers in the second quarter and the unfavorable exchange rate, which resulted in some volume moving to truck, as it became a more viable option. As Jeff discussed earlier, to a larger extent, the service issues were resolved during Q3 and we expect gradual improvement in our intermodal business, as some of the volume that left the railroad earlier in the year returns during Q4 and into 2016. The Lázaro Cárdenas cross-border business continued to show strength in Q3 and we're continuing to see that trend in Q4. Going into 2015, our cross-border intermodal represented less than 2% of our total Lázaro intermodal business. It's grown to about 9% now and we look for the volumes to grow further with the opening of the new APMT container terminal in 2016. In terms of our U.S. intermodal business, we're already receiving favorable comments from our intermodal asset partners regarding our new Wylie Texas intermodal terminal. One customer noted that their trucks were getting in and out of the terminal in under 15 minutes. That kind of service should boost utilization and be a positive selling point in growing our U.S. intermodal business. Overall, we expect our intermodal franchise to continue to be a driver of growth as customers experience the positive impact of our service improvements, the new Wylie intermodal facility and the APMT terminal. Slide 15 provides a summary of our automotive business. As discussed previously the service issues earlier in the year resulted in lower volumes and in some cases force our customers to find short-term alternative capacity to move finished vehicle. We're also starting to see the impact of lower fuel prices on the compact and mid-size market KCS supports out of Mexico. As fuel prices decrease, consumers typically trend towards purchasing larger vehicles and light-duty trucks. In addition, this slide also points to the fact that the first part of 2016 will be impacted by significant retooling efforts by our domestic automatic manufacturers. These plants are scheduled to be down for several months in early 2016, but the good news is we believe the retooling and expansions will result in significant volume growth for KCS, which we will begin to see in the back half of 2016. I would also like to spend just a moment on the VW plant in Puebla. Earlier this month, industry news suggested that planned investments in all parts of the VW network would be reevaluated based on their recent issues regarding their diesel vehicles. Historically, Puebla has represented about 10% of our total finished vehicle volume. We've already seen a slight decrease in the production from this facility. And the industry news also suggests the company-wide cost cutting measures, which could potentially impact production at a number of the facilities. We are in continuous discussions with VW and we'll continue to support this important customer. If the Puebla plant experiences substantial production cutbacks, we will redirect the use of the excess automotive equipments to support the other plants in our Mexican automotive customer base. Before leaving the automotive discussion, I'd like to reemphasize that KCS is looking ahead to very meaningful growth in this business. By 2017, the GM and Chrysler ramp up should be in full force, Audi and Kia will be approaching full production, and then comes Mercedes, Infiniti, Toyota and BMW. Furthermore, we believe there will be additional manufacturing capacity added over the next five years. We continue to feel very good about our automotive franchise being a long-term growth driver for KCS. Finally, in the energy segment, we saw strength with both utility coal and crude oil shipments. The peak cooling system resulted in KCS achieving good sequential coal carloading growth in the third quarter. As Pat noted, we also took advantage of excess capacity to provide a coal customer with some fixed variable contract options, which allowed the customer to keep its generating units online and take more coal in the third quarter than they had originally been forecasted. And Pat also mentioned, the deal we agreed to, does not commit KCS to any service guarantees. We expect crude oil shipments to continue to be highly variable as the Mayan/WCS spreads continue to fluctuate. During Q3, we saw strength in these shipments as Canadian crew moved into the U.S. Gulf region. We believe we will continue to see production at existing facilities continue to grow into the future. We'd, however, experienced lower than planned frac sand volumes and we do not foresee of recovery in these shipments in the short-term. Finally, on Page 17, we provide our fourth quarter sequential outlook for each of the commodity groups. We're forecasting the fourth quarter to be similar to the third quarter, which is positive, given that we usually feel slight drop off in Q4. In addition, there maybe some upside potential with some of our commodities like utility coal, crude oil, petroleum and plastic, we'll just have to see how that turns out. Given the complex macro environment, especially with respect to energy, volumes for a number of our commodities will likely continue to be highly volatile in the near-term. This will provide us with opportunities and challenges. Nevertheless, the general trend appears positive as we move towards 2016. And with that, I'll turn the presentation over to our CFO, Mike Upchurch.

Thanks Brian, and good morning, everyone. On Slide 19, third quarter volumes declined 2% and revenue declined 7%. As Pat indicated earlier, we saw a significant negative impact on our revenue growth rate from declining fuel prices and the peso depreciation, combining these factors negatively impacted revenues by $55 million or 8 percentage points. Adjusting for fuel and foreign currency, revenues would have increased by about 1%. Our operating ratio improved 90 basis points to 65.2%, reflecting the benefit of lower expenses and increased pricing. Sequentially, incremental margins were strong 72% on revenue growth of 8%, while expenses only increased 3%. Reported 3Q 2015 EPS was $1.20 per share, while adjusted EPS was $1.21, down 6% from third quarter a year ago. In addition to declining operating income, we experienced increased interest expense of $4 million, impacting EPS by approximately $0.02 in the quarter, as a result of the July debt offering. I'll comment more about that in a few slides. And for your convenience, we have also included the additional income statement detail from the appendix, including foreign currency and income tax impacts. On Slide 20, operating expenses declined 8%, driven largely by foreign exchange impact and lower U.S. fuel prices. Lower incentive compensation expense and benefits in purchased services from a mechanical maintenance contract restructuring, also benefited year-over-year expense comparisons. While offsetting, we had higher depreciation from capital investments, wage inflation, increased car hire, litigation costs and increases in Mexico fuel prices. I'll cover more details in certain key expense categories on the following slide. So starting on Page 21, compensation expense declined $12 million or nearly 10%. Lower year-over-year incentive compensation expense of $10 million is due to increased incentive accruals booked a year ago in the third quarter, while 2015 incentive accruals remain at much lower payout percentages. Also, experienced a $7 million benefit due to foreign exchange. Offsetting those declines were increases due to wage inflation and incremental headcount. Overall, quarterly average headcount was up 220 FTE or 3%, and was mainly in our operations group. Our third quarter average headcount increased 260 in Mexico, largely due to the result of our efforts to improve our service levels, offset by 40 a FTE decline in our U.S. labor force. On Page 22, our fuel expense declined $30 million or 28%. During the quarter, we benefited from lower fuel prices in the U.S. specifically $1.73 per gallon compared to $2.93 a gallon during the third quarter of 2014. However, in Mexico, on a constant currency basis, we saw a 4% increase in fuel prices from $3.29 to $3.43 per gallon. Mexico began eliminating the monthly price increases earlier this year, and since then we have seen stability in our Mexican fuel price. And finally, our fuel lag benefit during the quarter was $5 million all from our U.S. operation. Finally, on Slide 23, let me address our cash flow priorities. We continue to generate positive free cash flows despite significant capital investments to support our growth opportunities. For 2015, we still believe our capital investments will be approximately $650 million to $670 million, the range we communicated during the first quarter earnings call. Our next priority will be to continue to provide our shareholders a meaningful return as we have since 2012. Our annual dividend has steadily increased 69%, since we established the dividend in 2012, and will provide $144 million back to shareholders in 2015. Additionally, in May of this year, our Board of Directors approved a $500 million stock repurchase program to be funded through cash flows available liquidity and incremental debt. In July, we did issue $500 million in a new 30-note at 4.95% to repay commercial paper and begin repurchasing our shares. And I might just note that we would expect our 2015 interest expense to be approximately $80 million and for 2016 approximately $95 million. During the quarter, we opportunistically repurchased approximately 1.2 million shares in an average price of $93.57. Including the second quarter purchases, we have now repurchased a total of $136 million of our stock for almost 1.5 million shares at an average price of $93.44. Finally, we intend to maintain a prudent capital structure to keep our investment grade rating. We continue to believe we have some incremental opportunities to purchase leased equipment and lower our overall equipment costs. Since 2011, we have increased our percentage ownership of rolling stock from less than 20%-owned in 2011 to now over 60% at the end of the third quarter. This has allowed us to save approximately $56 million annually in equipment expenses and improve our OR by over 200 basis points. Our target leverage ratio continues to be in low-2s giving us ample flexibility without jeopardizing our credit rating. And with that, I'll turn the call back over to Dave.

Thanks Mike. On balance, we're very pleased with the progress we've made in the third quarter, both commercially and operationally. We still have work to do, but we're more confident than ever that we'll be in good shape at the end of this quarter. And we look forward to ending 2015 on a strong note. We'll now be happy to answer your questions.

[Operator Instructions] Our first question is coming from the line of Allison Landry with Credit Suisse.

This is Amit Shah calling in for Allison actually. In terms of the temporary pricing actions you took in the coal business, should we think of this as a one-off or do you see opportunities in other parts of the network to implement similar incentives to improve demand intensity?

I would say, right now, considering a one-off; again, as we saw in the second quarter, our coal volumes were extremely weak, creating this opportunity for excess capacity. But I would say, that at this point we see it as a one-off situation.

Our next question is from the line of Matt Troy with Nomura Securities.

I wanted to ask about coal, specifically, you've had one customer that's been problematic, I know you took some pricing actions during the quarter, but is there anything you can do longer-term to mitigate the volatility in this commodity group. It's been kind of a rollercoaster for the last couple of years.

I don't think so, Matt. I think that's one of the things that we talk a lot about here is when you look at the coal, crude, and even grain to some extent, because of droughts and floods, there is just a lot of our business now that -- a more of our business, and not just us, all the rails that is commodity-based and going to be more volatile. So there are things certainly we can do longer term in terms of pricing and making sure that we're getting an adequate return. I think the volatility in some of this business is just going to be a fact of life going forward, and we just are going to continue to find ways to deal with that. Makes it difficult from a long-term capital investment program, but that's where pricing and yield management strategies are going to become more important.

I get it. I was just referring more to that one specific customer, which seems to be a thorn in this side of the business, but I understand. I guess my follow-up would be just Mexico, you said the resources are there on a headcount basis. Just curious what the efficiency curve is there, as we look forward over the next couple of quarters? And when you expect those people to be and those resources to being self actualizing? And does it change the actions you had to take, both hiring and the pay levels? Does it change the margin profile of the Mexican business in the near to intermediate term or structure, should we think about it being similar to what it has been historically?

The last part your question, does it change the margin or outlook? No, we're becoming more fluid. And as these crews come on, I think Dave mentioned last quarter that we'll probably find ourselves a little fat on crews, but what that will do is set us up for good to be able to handle attrition getting into 2016, so there's not this need again to have such a large hiring class, as we saw in 2015. We've got all the -- we've talked about a 250 number for 2015. We've got those guys hired on board. Everyday those guys, the promotions, trainings, they've progressed from yard operations to road crews. So as I referenced, we'll see that continue through Q1 here in '16, but everyday those guys are kind of marking up in the areas we need them. So again, you've got the base on board. You've got everybody focused in the right direction getting those guys out, whether they are needed around the systems. So I'm feeling good about certainly the resource level in Mexico we're at.

Yes, Matt, I might just add, on a short-term basis, obviously there will be some incremental compensation expense associated with the hires, but we would certainly hope to see that offset with incremental volumes and revenues and margin from revenue.

In the last quarter or two, we talked about the new agreement to run the longer train, so we actually expect to get some efficiencies out of the new 9,000 foot train length over the long-term.

Our next question is from the line of Tom Wadewitz with UBS.

So I know, Pat, that you're not going to give us volume and revenue guidance for 2016, I understand that, but I was wondering if you could elaborate a little bit on some of the automotive comments, just in terms of, it sounds like there are a couple of headwinds that would affect 2016. So when we think about first half, should we be modeling auto volumes maybe that are down, or are you just saying, don't get too aggressive on the pace of auto volume growth. So I'm trying to ask you to be too specific, but just kind of directionally, how do we think about automotive going into '16?

When you think about 2016, obviously, the retooling efforts on some of the domestic companies is going to have a pretty significant impact on the first part of the year. So I would certainly suggest that that's taken into account. What I would tell you, though, is we have a number of different facilities that are continuing to retool and then come online. And so as we see it, we feel very comfortable that we're going to be, on a total year basis, very much the same as this year, but I would also tell you that that first piece of the year, especially around the domestics as they retool and as they look at the new models, that will definitely have an impact. Now, obviously all of those things are subject to change, as they need to make different changes in their models and as they respond to some of the market forces that are occurring in the automotive industry right now. But that's kind of way I would look at it.

So when you say, total year the same, you're saying kind of volume flat on a full year basis?

Yes, we would say that our total year volumes are going to be similar to 2016 from an automotive perspective, when you think about the entirety of the year.

And then one on Lázaro, the volume growth was really strong in second quarter in Lázaro, and then it did slowed a bit in third, I think you commented on this some, but just wanted to see if you could give a little more perspective on whether you expect that to accelerate? And is there an issue in terms of slowing Mexico economy that are hurting Lázaro volume?

I would say that the Lázaro volume, as I said in my comments, really slowed, because of the service issues we experienced in Q2. Now, different shippers make different decisions as they move through the year. And now that those issues are behind us we are continuing -- we have many of our customers who have a desire to move rail, but they are not going to be able to switch immediately, and so we expect over the next certainly 90 days, but into 2016, as well, for those volumes to start to return. But obviously the competition is stiff and we need to make sure that we have a great product. And I believe that just Jeff has really rolled out what we have done to make our service and other things very competitive. So we feel comfortable that we will continue to se steady volume coming back into our intermodal businesses, especially at Lázaro, it's just our product we believe is the right product right now.

And you've got to remember too the opening of APMT terminal in the middle of the year is going to unconstrain Lázaro from a port standpoint.

That will be in July; is the plan for that to occur July 2016 for the APMT terminal.

And we're very encouraged by the growth in our cross-border.

So you sound like you're still pretty upbeat on Lázaro growth. Looking forward, it just maybe a bit of a bump in third quarter?

Absolutely.

And I would just say the same thing with autos. I mean the things that are going on the retoolings that Brian talked about, long-term those are going to be positive for us. In the short run, while those plans are under the retooling process, they're going to take some volume away, but longer term, this just continues to strengthen our auto business.

Our next question is coming from line of Chris Wetherbee with Citigroup.

I wanted to touch a little bit on peso and FX, as you guys think about sort of the pricing environment in Mexico, maybe how that could be impacting pricing? And then maybe thinking about sort of competitiveness in intermodal and auto, specifically, have there been any issues in terms of that headwind that we're seeing from FX? Just want to get a sense of how that's going to play-in out in Mexico?

I would say, as Brian mentioned this in his comments, first, that was a bit of a factor. I think it was difficult to sort out over the last few months as we saw some of our intermodal volumes going to truck. How much of it was service? How much of it was peso? So we just can't precisely answer that question. We know that we have gotten some inquiries, and for the lack of a better word, I guess, pressure from some of our ocean carrier customers over the last several months, who are looking at trucking options from Lázaro that are peso denominated. But if you look at our performance at Lázaro, I don't think we can say for certain that the peso weakness has cost us a lot of volume, we're still growing. But it's something that we're keeping our eyes on. So looking back, I don't feel that the peso exchange rate has had an impact on our pricing environment in Mexico. And it's really hard to say with any degree of confidence or precision that it's cost us business. But certainly something that we're looking at just in terms of what it means for a lot of different things in Mexico that could affect our business. We get questions, and I'm sure you're looking at the grain business, export grain is a big part of our business and that's all dollar based. So the strength of the dollar, the weakness of the peso are going to cost us in terms of Mexico sourcing grain from other markets. We haven't seen it yet, but it's certainly something that we're paying attention to. Not a very specific answer to your question, but it's something we're watching closely and obviously it's outside of our control. But so far, we don't feel that it's had a big impact on our business.

Just to give you a little more color on the intermodal side, the only advantage in not price. I mean people like the stack service. It does provide better security. So there are some other benefits that the customers look at. They can move their empties back to vessel, all in big unit trains. So there is other advantages. And on the grain side, if you think about what we do for the major customers in Mexico, we're actually part of a logistics chain. We run the 100 car trains in their facilities. Some of these guys are making corn syrup. They got have their product there. They've got to have it on time. And the quality from rail is always better than the vessel, because every time you rehandle grain, you loose some quality. And we have a better more reliable service to those customers than they can get by trying to come into vessel. Because remember, if it comes in by vessel, it's still going to move by rail. It still got to get unloaded, move to rail, and then still moved into their facilities. So we offer more advantages than just price.

And then just a quick follow-up, sort of looking at your slide that goes through the sequential changes in carloads for the fourth quarter. It would seem with sort of almost 70% in the neutral to favorable dynamic that you might be able to see sort of positive carload sustain through the fourth quarter. Just want to get a rough sense, if there is anything else I should be thinking about, when I am looking at that slide in that context?

We absolutely feel very comfortable that the fourth quarter is going to continue the same trajectory that we have in the third quarter. And we don't see anything out there that's going to change that volume.

Yes, Chris, just to remember seasonality obviously from thanksgiving to the end of the year, things do slow down.

Our next question is coming from line of John Barnes with RBC.

First, on the Mexican hiring, again, just going back, I know you talked about having completed what you need to do now. But as you look at growth going forward in Mexico, how do you ensures that you kind of stay up on this, so you don't have a repeat of this issue, especially given where kind of the union felt down in terms of the pools of applicants available to you?

We're just staying in front it. And we've already got several requests in for personnel for our 2016 plan. We're working towards that. As I mentioned, I think we'll be a little fat, when service restores. So again, as we lose people through normal attrition, you're already going to have a stronger baseline in place. So the union relationship continues to foster. And again, we're doing things, they're showing support now, we've got names flowing. So I don't see a big issue for us. It's just to make sure we're staying ahead of it. And right now I feel that that we're doing that.

And then going through some of your comments, you talked specifically I think in your slide deck, you said something to the effect of kind of an expectation of a delayed peak season on the intermodal side this time. Can maybe you talk a little bit about why you think we're seeing a delay? And I hate to be that sort of short-term focused, but given some of the freight-related data points, unfortunately we would kind of have to be right now.

No, that's no problem. This is Brian. John, basically what that comment is about is based on year-over-year comparisons and what we got from our vessel operators, the intermodal volume that came in was delayed about two weeks, and so we saw it a little bit later. It's certainly not a large delay, but we're already right in the middle or through that peak. So we feel very comfortable that we kind of timed it right, knew when it was, but it just was not. Sometimes that shows up in that last week of the third quarter, depending on the way the retailers and others are bringing products into the ports. So we feel like we time that very well and we're already into that and through a part of that week.

Our next question is from the line of Ken Hoexter with Merrill Lynch.

Can I just get a clarification, Brian, on the port of Lázaro, is that a six-month delay on the opening of the second concession? I thought originally it was suppose to open by the end of 2015, so we were looking for a solid growth through the '16?

No, no. They are right on-time and we're looking for an early July. There have been articles written that some of it may move as early as May, but we are still looking for an opening of that terminal in mid-July 2016 and that's been the same for number.

No. One thing they've talked about is what they call a soft opening.

Soft opening.

Where they get their equipment and they test their equipment. The government has to come in and certify everything. So what they are talking about by mid-year is been fully operational. That might be some of the confusion.

And thoughts on Port Arthur development, is that stalling, given what's going on with crude prices or is Global going full steam on that? What are your thoughts on your development there and what you need to invest in preparation for that?

Right now, all of the development that we've got going on in Port Arthur, especially with the Global Group is going on as planned. All of the different things that are being done with the permits and working with the government and all the different things that have to be done are right on schedule. We feel very comfortable that that is going to move forward just like we think and we'll be ready in 2017.

In terms of your second part of your question, Ken, about the capital, because this is still two-plus years out, we really aren't doing anything today to anticipate that facility. But we certainly have plans looking at some options for expansion and ways we can improve, not just because of Global, but the overall Port Arthur/Beaumont Nederland market, things that we are starting to plan for 2016 and 2017 that will help us in that region. But right now, they are deep into the permitting process. We've had very active and ongoing dialog with Global and in fact some of the customers that they are trying to secure longer-term commitments. So everything is going pretty much as scheduled as Brian mentioned.

And if I could just get a quick clarification from Jeff, because it sounded like, as Mexico really starts to pick up the pace, you talked about getting fat. What kind of visibility do you need in order to, if volumes, I guess, slow down to then cull or can you keep staying ahead if volumes do pick up the pace? Because it seemed like the last two weeks we've seen a great improvement in velocity. I just want to see if that's a trend that you think continues here or your thoughts on that recent improvement?

Yes. And why I've separated Mexico and U.S., again, I think the velocity you saw mainly for the last few weeks has really been around the U.S. side. And again, I think we're operating even near 28 in the last few days. So, again, the message is U.S. is stable and we're back to performing pretty close to where we historically have. U.S., again, the velocity side is still lagging a bit. But the crew is coming on. The capacity is the other thing I really haven't touched on. The benefits we're going to get out of Sanchez. That means fluidity on that whole north end. It's not Sanchez and the terminal below that's going to help process cross-border and fluidity to and the central region as well. We've got some of the capacity projects coming online here yet in Q4 for the southern region for the quarter out of Lázaro, one additional siding and some siding extensions. So adding all that together, we should just continue to help promote and get us back to kind of normal production.

Let me help kind of put a nail in this, because this question keeps coming up. We have reset our relationship with the union. The head of the union with his main players was up there three weeks ago for Royals game. We are all working together. He has made announcements in front of his union team that we got to work with the railroad. They're spending a lot of money on capital. They're a good company. They're concerned about our safety. We have to make sure that we move the freight, that's our obligation. We have, as you know, from a couple of years ago, a new director, the Senior VP of HR who has a lot more labor experience. So we have totally redone the relationship we have with the union, and we are not having any problems with them, getting employees to hire. We improved that elongated process we had from physicals to approvals, to security checks. So we feel that is fixed and it is as efficient as the U.S. So we will regulate crews like we have done in the U.S., and we will do it very efficiently. So we do not see that as being a problem in the future.

Our next question is from the line of Justin Long with Stephens.

First question I had on the pricing environment, it remained strong this year, despite the volume decline we've seen year-to-date. Could you just comment on the sustainability of the increases that you're seeing? And just in your opinion, is there anything that would get you more concerned about pricing potentially weakening as we head into 2016?

Well, we see, as we've talked about in the presentation is, right now 4.1 very strong. We don't have anything on the horizon that we would say would deteriorate that pricing environment. Based on Jeff's comments and the amount of capacity we have within the system and our ability to move the freight now with all of the different things that have been put in place operationally, we feel very comfortable that we're in the right side of the pricing environment and we continue to see that into the future. Obviously, that can change as others make different choices. But right now in our world, we feel very comfortable that we're in a good space from a pricing perspective.

And as a follow-up, you talked a lot about the headcount situation in Mexico, but if we just look at overall headcount for the business and think about next year, could you provide any high-level thoughts? Just assume we return to a low-to-mid single-digit volume growth environment, how would you anticipate headcount would need to trend in that scenario?

Again, we'll manage that as we've done in U.S., and that's why we continue to talk about these separately. As we've shown in the U.S., certainly going from a furlough of 8%-plus of workforce back to basically fully staffed. We'll just have to manage that. And I think we've shown we can manage that, as volume trend. So that's something that, as we illustrate, there is a little bit of a lag effect as we see volumes increase and decrease on a rapid basis. But as things, the outlook continue to stabilize, I think you'll just manage that headcount as appropriately with the volumes.

Our longstanding goal has been to try to keep headcount increases below volume increases. Obviously, we're in a tough environment here in 2015 with volumes declining and some service issues. But I think you should expect us to continue to have those goals going forward over the long run. We just need to kind of work through the situation on a temporary basis.

Our next question is from the line of Tyler Brown with Raymond James.

Jeff, just thanks for the detail on the KCSM, the KCSR dwell and velocity, I thought that's very helpful. But I'm just curious if you could give us some details on train lengths. Basically I'm curious as the concession from the union has helped improve that metric or if it takes longer to kind of implement that into your train design.

It will be something, again, we graduate into. We are running some trains longer coming out of Lázaro and you're seeing that, you're seeing that in some other territories. The other thing we'll continue to just make sure our plan coincides with how and what we want to run length-wise. Some of the other efforts you'll see going on into the future with siding, spacing and siding extensions is going to allow that flexibility to continue to grow. So certainly something I think is going to be a positive. We're already seeing that from our train length increases. And I think that's something I'll continue to focus on and we'll continue to get benefit here going forward.

And then just maybe a question for Brian or Pat, but I was just wondering if you could give us an update maybe on where we are in terms of the lane awards for those new auto plants in Mexico. Curious, if you're seeing kind of what you would expect from a share basis? And then also are you seeing any awards north of the border?

What I would tell you from a lane award, we're not going talk specifically about customers, but we feel like we are getting absolutely our share of that as well as being very competitive on other things that we're participating in. We feel very comfortable that we're going to come up in a very good space from an automotive perspective, as the new plans come on. On the north of the border, it's similar to what we have right now both on the southbound side parts. But no, we do not have anything north of the border to report other than what we currently move.

And then if I could just squeeze a very quick one. And this is a bit of an esoteric question, but what percent of your business is moving in boxcar?

We'll have to get back to you.

We'll have to get back to you on this one.

Our next question is from the line of Bascome Majors with Susquehanna.

Looking at your chart, the intermodal volumes, they've been down year-over-year in each months since May, but you saw pretty encouraging narrowing of that gap over the last four weeks relative to last year. I'm just curious based on what you're hearing from some of your intermodal partners, who have temporarily moved some of your business to truck, when do you think we can return to consistent year-over-year growth in intermodal?

I think when you think about intermodal, it is a product that is sold, is very cyclical in its nature. There is also a piece of it that comes in with the shipping lines. We feel very comfortable now that the service issues are behind us, have been resolved, that we'll start to see that come in. Obviously, this is a heavy shipping period, and those commitments have already been made from the shipping lines. So as they get through their holiday, retail timing, we expect that to start to come back in later here in the quarter and then into 2016. So it's not all going to come back at once. We understand that. But we do feel that the new service, they're going to start to see the service, they're going to see the benefit of the Wylie, Texas yard, how quickly people are moving in and out of that yard, and also the additional trains that we put on, the additional train length that Jeff talked about. So a lot of positive things, a lot of great feedback from our shipping partners, and so we feel very comfortable moving into 2016, that is going to be a positive space for us.

And just want to circle back to the success you had in stimulating some of the coal demand with the fixed variable adjustment on pricing. Is this Powder River Basin coal where you've done that?

Yes. All of our coal is Powder River Basin coal.

So just extending from that, is this a holistic adjustment through the supply chain from Wyoming to the customer or is this just something that you've done on your side?

A little bit of both. I'd say more of the former, because obviously, it's not a move that originates and terminate on KCS, so there is another carrier involved. So I would say, it's more of the former. It's a complete -- the incentive is for the full move. In most cases, depending on the location of utility, the majority of the line haul move would not be on KCS.

Our next question is from line of Scott Group with Wolfe Research.

So I think you said, kind of you're guiding to flattish sequential volume third quarter to fourth quarter, which implies like a couple of percent of volume growth year-over-year. I would think that's an environment where you can grow earnings. Just kind of make sure I'm not missing anything the way we're thinking there.

Grow earnings on a year-over-year basis or?

Yes, if volumes are up a couple of percent, as you're expecting, I would think you can grow earnings?

Yes, we're not, as Pat indicated, not guiding to anything specific, but you can certainly conclude that with incremental volume, and as you know Scott, I indicated we had some pretty strong incremental margins of 70% plus.

Just want to follow-up on the question on the competitive dynamic. Conceptually, do you think about changing some of the truck competitive business that's priced in dollars and to pesos to kind of avoid some of this competitive issue? And then, can you talk about that competitive dynamic with Ferromex and what it's look like they are doing it? And how that impacts your volume and pricing expectations for next year as well?

I would say, it doesn't really affect our volume and pricing per se, we haven't really seen any change in behavior in terms of the competitive landscape in Mexico. We know that they are teaming up with U.S. railroad to be more aggressive in some of the Intermodal markets that we feel very good about our service, and the service we have, the joint-line service with the UP on some of that premium intermodal and automotive business, very service sensitive. We feel like, we have the best product and the best service and it's been in place for more than ten years. So we think we can compete and defend that part of the market, as they try to get more aggressive. And I think the awards and the dialogues we're having with customers has supported that view. So on the other hand, we are on our toes, and feel, that if we continue to provide the kind of service we really feel that because we own the railroad on both sides of the border that there is a real advantage to the way we can face the customer. And we hear that constantly from our customer base. So we feel very good about our ability to retain and grow that part of the business. But we need to be on our toes and make sure that our service, consistency and reliability of our services is as good as it can be to defend and grow that business. But Scott, we haven't seen any predatory pricing on the FXE's part, if that's your question.

In fact, some have been talking about that aspect, but when you look at the auto results, I mean their auto results were down further than ours were in the third quarter. So there is certainly no share going to FXE there.

The growth on the auto that they have enjoyed has been on plants that they serve exclusively, like Hermosillo, because they've had strong production, so they've enjoyed that. But we haven't seen them buying any market share, if that's your question.

And then just on the peso dollar question.

Can you restate that question?

Yes, on the business that is competitive with trucks, do you think it makes sense conceptually to put more of that priced in pesos, so you don't have this currency discrepancy?

No. Again, we don't feel -- I mean, we can't really point to and come to the conclusion that we lost share because of the exchange rate. Again, the ocean carriers where this is mostly -- where it would be an issue, their business is dollar base for the most part. So while they certainly have truck options, there is an unlimited tuck capacity in and out of Lázaro. And there are a lot of advantages to rail, unrelated, as Dave mentioned, to price and currency, so again, something that we watch closely. We don't feel that its cost us market share. Lázaro's continued to grow. So it certainly hasn't affected our growth rates in and out of Lázaro. And it's important for us, as we've talked forever to maintain that balance in peso revenues and cost, so that we have that sort of natural income statement hedge. And at this point, we see that continuing to be the case.

Our next question is from the line of Brandon Oglenski with Barclays.

This is Eric Morgan on for Brandon I just want to come back to grain real quick. Your outlook is pretty positive. You've recently talked about moving some out of storage in advance of the strong harvest. And just really on the comments on the export business, that seems to not have taken as much of a hit from FX. Is there a precedent for the export business having a less sensitivity to FX movements specifically compared to some of your peers?

I think the difference is ours is a normal export into Mexico, whereas others sometimes are exporting into Asia. Ours is a little, like Dave mentioned kind of almost a service-based product, if you will, where their plants depend on the consistency and things that we provide. And we are much more consistent with that volume than maybe some of our other competitors. And primarily, it is the moves down to Mexico and then also the moves back this way. So it's something that's historically a normal thing for our railroad. And we feel very comfortable that that's going to continue. And especially in today's environment where you have a strong harvest, it's been a great quarter and we see that going continuing into the future.

If you look back over the last several years, there has been fluctuation in peso dollar rate. We have never seen currency be a major driver in where the ultimate customers that we're serving source grain. We've seen a little bit of grain coming in from South America recently, but it really isn't a significant shift in the way Mexican sources corn. Mexico sources corn only during the drought years, did we see where there just was no corn available in the U.S., did see any kind of a sizable shift. But once we got the crop back and the inventory back, the U.S. business came back pretty quickly. Now, is that going to be the case going forward? We've seen a fairly high degree of peso deterioration here for some period of time, so that's an unknown. But we just haven't seen our grain business be terribly dependent on the exchange rate.

Our next question is from the line of Brian Ossenbeck with JPMorgan.

It's James Allen on for Brian Ossenbeck. We were wondering about your cross-border intermodal grain and whether it's leading to an imbalance of equipment heading out of Mexico? And if so, how and when you need to remedy to maintain growth rates?

I'll take this as an old ocean guy. Basically it's fairly balanced, and we've always maintained the return of the equipment back into Mexico. So I don't quite really understand totally the question. But no, we don't see any changes from what we've had in recent years. So everything is operating as it always has.

Again, and maybe as a follow-up to a Tom's question. Aside from infrastructure investments in Mexico, what are your expectations for the overall economy there?

I'm sorry.

Question is about the economy in Mexico. I think, Mexico ends up being fairly tightly linked with the U.S. economy, given the amount of goods that end up going north into the U.S. But they've done a really good job managing their overall inflation rate, which is now running below 2%, unemployment is below 5%. We've seen a little softness in the auto production, but some of their manufacturing, labor indexes and business condition surveys, all look reasonably good. But again, I think they are largely linked to the U.S. economy. So they move as, as we move here in the U.S. And as you know in the U.S., it's been kind of one step forward and I have to step back.

Our next question is from the line Jeff Kauffman with Buckingham Research.

As we look out, let's go beyond 2016 and kind of take the three to five year view. Mexican economy holding in there, currency in theory should be good for export, but energy is going to hurt the economy, auto has been a little soft. Would you look at the capital spending of $650 million to $670 million, how much of that is just regular maintenance away and what you'd consider kind of maintenance level CapEx? How much of it is, let's say, bucket two is improving existing operations, whether it's U.S. or Mexico and how much of it is new investment to accommodate growth we don't have?

Well, historically if you look at it on a percentage basis, we've been at around 10% to 11% of capital has been maintenance. As we've improved our network that's gradually dropping down into the 10% range, maybe the 9.5% in outgoing years. The rest of it is all driven by IT equipment purchases, ETC locomotive purchases and adding capacity in the infrastructures. So that kind of gives you your breakout. While auto may be down a bit this year, we're still looking long-term at a lot of growth coming out of Mexico on automotive. I mean all these new plans that are planned that are being built, that's definitely going to increase the production. You got to remember, we not only go northbound, we also go southbound for export to Lázaro Cárdenas. So we expect to continue to add capacity in Mexico, because we feel it will be needed.

Ken, a high level 10% of that capital is PTC and GAA, and the rest of the 90% is almost evenly split between maintenance and growth, if that helps you a little bit.

And you mentioned that you're not really investing a lot in Port Arthur right now, because that's kind of two years out. What are some of the major capital projects that you would kind of cluster in that or not spending on it yet, but it's a big part of three to five year growth outlook?

Well, again, the biggest part of our investment for the Port Arthur Crude Terminal will be locomotives. And so we would all invest in locomotive as the growth materializes, so we just aren't going to be in a situation, where we're going to make a huge capital investment if the business doesn't grow. We have already made some capital improvements around the Port Arthur area in terms of yard expansion sidings other things to handle the growth in capacity there. But those investments are also useful and necessary for our overall cross-border volume growth in intermodal automotive and grain, because that area is not only going to experience growth because of the energy markets, but that's a critical part of our network to and form Mexico. So again, if you just look at the discrete CapEx that is related to Port Arthur it's going to be primarily locomotives.

At this time, we've reached the end of our allotted time for questions. And there is time for one final question today, that question is from the line of Cleo Zagrean with Macquarie Group.

My first one relates to automotive. I am trying to understand to what degree this retooling campaign is different from the historical pattern or different since the second quarter, such that now we are looking to a flat auto growth for next year, even off of what one could expect could have been easy comps this year?

This is a normal cycle for all automotive companies. When they have a heavy manufacturing environment, they'll need to go in and do a reset. They'll go in and do preparations for new models, new model years. And so this is a normal standard process that they go through. When we think of, and I think Dave mentioned this, and I mentioned it in my comments, we see the automotive growth over the next two years being significant and that we'll be a large player in that. And so this is just a normal piece of the automotive world where they need to go in and retool the plant, revamp the plant and be ready to move forward with new models and additional volume. So we feel very comfortable that the facilities will come down for a month or so, but that they'll be back online and we'll move forward with the automotive volumes and with the customers that we have, in conjunction with the new customers who will be starting and operating their plants in 2016 and 2017.

Absolutely agree with what Brian just said. Just remember, those happen to be our two largest customers down there and represent almost half of the volumes. And so it's a little bit unfortunate. They are both retooling in the first half of 2016, but there is not much we can do about that, and make decisions to retool and change models. It doesn't change longer-term outlook for that franchise at all.

And then if we could focus on intermodal a little bit for next year. Can you share similar comments for that, especially since now we are in the process of, I would assume, re-signing business for next year and we're also looking for easy comps similar to automotive.

As I mentioned, we're not going to give you 2016 volumes. But we feel very comfortable that with the service improvements, with the new Wylie terminal and with the new APMT terminal coming onboard that we will continue to move a significant amount of intermodal volume. And we feel comfortable that that is going to continue to grow into the next few years and we're very upbeat on that. End of Q&A

Thank you. Mr. Starling, I would like to turn the floor back over to you for closing comments.

I know the call has gone long. We've had a lot of questions. We appreciate everyone's interest. And we'll see you next quarter.

Go Royals.

Go Royals.

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