Canadian Pacific Kansas City Ltd. (CP) Q2 2017 Earnings Report, Transcript and Summary

Greetings and welcome to the Kansas City Southern Second Quarter 2017 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. 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, 2016, 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 the KCS website, www.kcsouthern.com. It is now my pleasure to introduce your host, Pat Ottensmeyer, President and Chief Executive Officer for Kansas City Southern. Mr. Ottensmeyer, you may begin.

Thank you, Melissa. Good morning and welcome to the Kansas City Southern second quarter earnings conference call. Slide 4 just lists the presenters for today. The same cast and characters you’ve become familiar. So I won’t introduce them. We’ll go directly to Slide 5, which summarizes our results for the quarter. I am just going to cover a few highlights and the rest of the team will get into much more detail. With revenue growth of 15% and volumes up 6%, this was clearly the strongest growth quarter we have seen in more than two years. With the exception of our Intermodal business, the strength was broad based across all of our major business segments. Our Intermodal business is clearly gaining momentum over the course of the quarter. As an example, volumes in the month of June were 6% higher than June of 2016. That momentum and growth has continued in the early weeks of the third quarter as well. Brian will have much more to say about our Intermodal business in a few minutes. The operating ratio for the quarter was 63.5%, which was 220 basis points higher than what we reported in the second quarter of last year. I will briefly remind you that there were a number of timing-related items included in the second quarter of 2016 that had an impact of reducing our operating ratio last year. We feel very good about the 63.5% OR for this quarter. It’s clean and solid and reflects the positive volume and pricing environment which we are currently enjoying, but also reflects that Jeff Songer and his team are delivering strong operating performance. Again, Mike will have – Mike Upchurch will have more to say about the timing events that I mentioned in a few minutes. I also want to call out the operating income with an all-time record for any quarter at $239 million, a 9% improvement over the second quarter of last year. We are very pleased with the positive momentum demonstrated by our operating team, as we have promised in the last couple of earnings calls, our operating metrics including terminal dwell are trending in the right direction and our network today is performing at a high level. Finally, earnings per share came in at a $1.27, which was a record for any second quarter and 14% higher than last year. Again Mike will walk you through some of those timing-related items that I referred to earlier from last year and those would suggest that our core EPS growth was actually higher than the 14% that we reported. Last quarter I suggested that the headline for our performance was solid and clean. Those words still apply to the second quarter, but I would add that we are gaining momentum both on the business side and on the operating side. And most of the storm clouds that have darkened our skies for the past few quarters appear to dissipating. The only need to look at the substantial appreciation of the Mexican Peso since the beginning of the year to conclude that the sentiment toward NAFTA and more importantly, trade relationships with Mexico has improved significantly. If you haven’t already seen that there is a great opinion piece in today’s Wall Street Journal with which we read it wholeheartedly. I’ll come back to that in my concluding comments and now will turn the presentation over to Jeff.

Thank you, Pat and good morning. Reviewing the key operating metrics for the quarter on Slide 7, velocity has remained relatively consistent over the past several quarters, although we did see some decline during the quarter mainly attributed to heavy unscheduled and seasonable traffic in the U.S. As Brian will highlight in energy carloads increased 41% from prior year. Dwell for the quarter of 22.2 hours was consistent with the prior year. The Mexico terminals did showed marked improvements over the past few months. Factors contributing to this improvement include completion of additional capacity projects in Northern Mexico, auto and grain facilities. KIA has completed the first phase of their track construction and we have started to shift our operation into that terminal. Improved management, additional capacity at Sanchez and cross border operating improvements are all having positive impacts on our performance. Other capacity projects completed in the past few weeks and includes 6 miles of double track in the San Louis area that supports fluidity in the automotive segment and a new 10,000 foot siding in the Port of Lazaro Cardenas. Turning to Slide 8, in U.S. we have recalled most of the furloughed crews to handle the increased bulk and seasonal volume while 8% of locomotives remain in storage. Productivity improvements during the quarter enabled us to handle 6% more volume with a 3% headcount increase. Including those in-sourcing in mechanical operations in Mexico, a portion of the increase in headcount related to additional PTC support positions in the U.S. and additional resources for our Mexico Network Operating Center, which has had a direct contribution to the performance improvements in Mexico. PTC will create additional demand on crews and locomotives as we ramp up our implementation, the resources are aligned to support this effort. We recently received approval from the FRA to begin revenue service testing on six sub-divisions, and we are on track with our overall PTC implementation schedule. Mike will provide additional detail regarding PTC financial impact in a few minutes. Capital outlook for 2017 remains unchanged at $550 million to $560 million. Remaining track work in Sanchez yard will complete this fall and new mechanical and fueling facilities in the terminals should complete by mid-2018. This will complete the current planned expansion work at Sanchez, however, we have ample space in this facility to continue to add infrastructure as volume requires. There is no change to the outlook for Sasol terminal project, which continued on schedule for completion late in 2017. I will close with a quick overview of our cross border operation similar to what we saw last quarter, total train volume all within the railroad gateway grew substantially with total trains count increasing by 15% versus Q2 2016. Time to process trains across the bridge, which is a measure of the time it takes to change crews and to complete customs processes improved 13% for South bound traffic and 5% for North bound traffic. These service improvements have been achieved through efficient operational management and work conducted by our process improvement team. The continued improvement in South bound traffic is also related to the additional capacity in Sanchez yard which allows more trains to arrive directly into the yard without waiting for other trains to depart. Two additional projects that should continue to support our cross border growth are the implementation of international crews and co-location of Mexico and U.S. Customs facilities. Pilot test for each of these initiatives will begin in Q3. We were encouraged by the United States Trade Office summary of objectives for NAFTA released last week calling for streamlining and automation of customs processes. These objectives should continue to support our current and future initiatives for cross border shipments. I will now turn the presentation to over to our Chief Marketing Officer, Brian Hancock.

Thank you, Jeff, and good morning everyone. I’ll start my comments on Page 10, where you can see second quarter year-over-year revenue was up 15% and volumes were up 6%. Revenue continue to be negatively impacted by foreign exchange, but was more than offset by strong growth from five of our six business units. We also saw strong revenue per unit growth in spite of the foreign exchange drag driven by strengthening fuel prices and positive mix impacts. Core pricing also continued to be positive. Our energy line of business saw revenue growth of over 100% in utility coal, frac sand, and crude oil for an overall year-over-year increase of 90%. Positive pricing and fuel surcharge drove revenue growth along with improved length of haul this quarter due to more of the business having a final destination in Texas. 13% revenue growth in our chemical and petroleum business unit was primarily driven by the heavy fuel oil shipments along with solid performance on our south bound refined products and LPG business driven by the new Mexico Energy Reform. We also had a strong quarter and length of haul in this segment. Automotive revenue was up 29% over 2016, driven primarily by volumes compared with temporary plant shutdowns we experienced in Q2 of 2016. We also had good volumes from new plant openings and growth in production from existing plants. The Industrial and Consumer segment also showed improvement in the second quarter with a volume increase of 4% and 9% revenue growth. We had our strongest quarter in nine years from military shipments coupled with strong quarter in cement. Our paper volumes were also up due to temporary plant shutdowns we had in Q2 of 2016. We saw continued strength in our Ag and minerals line of business with 7% year-over-year revenue growth in the quarter, primarily driven by length of haul and pricing. With revenue and volume decreases of 1%, our Intermodal business continues to see stiff competition from low trucking rates and ocean shipping consolidation. On Page 11, you can see our outlook for the second half of 2017 from a volume perspective. Our Intermodal business is expected to pick up in the second half with continued growth in our Automotive business at the UP, growth of our BNSF cross border service offering and shipments from the new operator at the Port of Lazaro Cardenas. Chemical and petroleum will continue to show growth due to the refined product shipments as well as the ethylene crackers coming online over the next 24 months. Our Automotive business will be up year-over-year as we continue to see solid growth in this business segment driven by additional manufacturing capacity and improvements in our service. Our energy comps get more difficult, leading to a slight year-over-year volume decline in the second half in utility coal. With that said, we should see sequential coal volume growth in the second half driven by stable natural gas prices and low inventories across plants that we serve. Additionally, stable crude prices are driving continued demand for frac sand and our outlook for crude continues to be positive as well. Ag volumes should be flat year-over-year, but due to the completion of a new soy processing facility in Monterey, we will see a change in the way beans and meal are shipped over the next few quarters. Industrial and consumer will see volatility in the short-term as both steel and paper markets continue to see significant pressure on pricing against the truck market. We can see some upside to this outlook from military and cement shipments. On Page 12, there is a graphical representation of KCS’s non-vessel-oriented intermodal strategy. The important message from this slide is that KCS now has effective Intermodal products for all of our customers. The cross border franchise business continues to grow with the new BSNF service, we continue to be pleased with the customer response for the product and all the parties are prepared for the busy retail season that starts in the third quarter. The cross border interchange business with our partner Union Pacific also continues to show strength with increased automotive production in Mexico and the benefits that this service provides to our customers in the Midwest and western states. We are now working with all of the major IMCs and are able to provide our customers with access to the key railroads in important destinations throughout all of the U.S. and Mexico. We believe to being a good provider to all of the North American rail partners, as well as being able – and willing to work with all of the major IMCs allows us to serve customers with the most effective and efficient solutions possible. Slide 13 provides an update on our Mexico Energy Reform and its impact on our current results. As you can see, sequentially, we have seen an increase of 255% in revenue and 223% in carloads. 40% of our energy reform shipments year-to-date have been liquid refined products including diesel and unleaded fuel. These products and primarily bound for the new Howard facility in San José Iturbide. 53% of the energy reform carloads have been moving LPGs, which are used extensively in the residential areas of Mexico. We received most of these shipments from our partner interchanges in St. Louis and Kansas City bounds for existing facilities and numerous cities in Mexico. We thought we might also provide a few keys to success to watch for in this important new business. Rail will be a critical part of the new Mexico Energy Reform and supply chain. To complete long – to compete long-term, we must have origin and destination facilities that can handle unit train capacity on a daily basis, manifest service to small tanks will create a significant cost hurdle to customers competing in the refined products retail market. We also believe that destination facilities must have both trans load and storage capabilities to make the facilities attractive to a broader set of distributors and suppliers. Security and product safety are essential and we believe rail holds a significant advantage over other trans and options. We also know that being able to survey relatively large geographic area from a single facility will create the density necessary to establish a long-term low cost solution. The market already recognizes that current market consumption will need to be supported by additional storage capacity, as well as enhanced distribution models throughout Mexico. This capacity will help ensure quality and security all the way from the Gulf refineries to the retail locations throughout the country. And with that, I will turn the call over to our CFO, Mike Upchurch.

Thanks, Brian and good morning everyone. I am going to start my comments on Slide 15. Second quarter volumes increased 6% and revenue increased 15%. Operating ratio did increase from 61.3% in the second quarter a year ago 63.5% for the current second quarter. I would remind everyone that in the second quarter of 2016, we recorded a $34 million credit in operating income when we determined, we could utilize the Mexican fuel excise tax credit that included $17 million related to the first quarter of 2016. During the quarter, we experienced a $2 million loss on operating income from foreign exchange and we’ve provided additional details in the appendix on Pages 28 and 29. Despite that FX loss, we are encouraged by the recent improvement in the peso to about 17.5 as the NAFTA rhetoric has been replaced with enthusiasm by the U.S. NAFTA renegotiation objectives being centered around ecommerce, financial services, telecommunications, and intellectual property. Excluding FX and fuel excise tax credits, our incremental margins were above 50% and sequentially, our incremental margins were over 60%. I’ll cover the excise tax impacts more on the next slide to help you evaluate our operating income performance. Reported EPS was $1.27 up 14% and on an adjusted basis, EPS was $1.33 in the current quarter, up 9% from second quarter 2016. More income statement details including the gains and losses of foreign exchange can be found in the appendix on Slides 25 and 26. On Slide 16, to provide more insight into second quarter OR and adjusted EPS, we have provided a reconciliation to the prior year that includes the improvement in operating income with and without the $17 million fuel excise tax benefit we recorded a year ago that related to the first quarter 2016. And you might remember from our earnings call last year, we determined our ability to utilize the credit during the second quarter, which included retroactive application to January 1 of 2016. Moving to expenses on Slide 16, 2Q operating expenses increased 20%. However, on a year-over-year basis, expense comparisons were negatively impacted by both lower fuel tax credits and insurance recoveries booked in 2016. Fuel excise tax credits were $21 million lower, $17 million from the previously discussed 2Q 2016 credit that related to the first quarter and $4 million from lower excise tax rates. We continue to expect our full year fuel excise tax credit to be approximately $45 million to $50 million. Fuel prices also contributed to $12 million in higher fuel costs, while fuel consumption increased $7 million. Our comps were negatively impacted by the $5 million insurance recovery we recognized in the year ago second quarter. Finally, we also experienced expense increases in depreciation, volume-based car hire and incentive compensation. And one additional point on expenses, we expect 2017 operating expenses related to PTC to be an approximate $9 million headwind escalating to approximately $30 million in 2018 and peaking at approximately $40 million in 2019. Turning to compensation on Slide 18, compensation and benefits increased 15% as a result of $4 million in wage inflation, $4 million in incentive compensation, $3 million in benefit costs, $3 million in incremental headcount, and $2 million in incremental headcount as a result of the car repair facility in-sourcing we completed in the fourth quarter of 2016. As you can see in the bar chart, excluding the in-sourcing, our average employee headcount went up 3% well below our stated goal of keeping headcount growth below volume growth. Turning to Slide 19, fuel expense increased 28% driven by higher fuel prices and higher consumption. Fuel prices increased both in Mexico and the U.S. from an average of $1.97 a gallon a year ago, to $2.22 for 2Q 2017. And consumption was driven by the 6% increase in carloads and a 15% increase in gross ton miles. Turning to Slide 20, purchased services decreased $3 million. Our in-sourcing and renegotiation of maintenance contracts provided $11 million year-over-year savings. Offsetting those savings were largely volume-based increases of $3 million in hire car repairs and $2 million in trackage rights fees. Materials and other increased $8 million. Materials for repairs increased $6 million due to the need to stock parts for our in-source maintenance operations. And as a reminder, we recorded a $5 million insurance recovery in second quarter of 2016 related to flooding from March of 2016. That was offset by an incremental $3 million of flooding cost for a separate event in June of 2016. And finally on Slide 21, I would like to discuss our capital allocation priorities. First and foremost, we will continue to invest in capital projects that present good growth opportunities for our franchise. We continue to expect capital expenditures to be in the range of our guidance of $550 million to $560 million. It is important to note that 2017 should be the third year in a row of declines in our CapEx spend and as a percentage of revenue. In addition to our capital expenditures, we expect to invest approximately $20 million in Phase one of the refined product terminal in St. Louis. As for shareholder returns, our commitment to return capital to our shareholders started in 2012 with the establishment of a dividend and in 2015, with a $500 million share repurchase program that we just concluded in June. During that timeframe, we repurchased 5.6 million shares at an average price of $89.25, slightly below the volume weighted average price. And with four new Board members at KCS since our last Board Meeting in May, we will have discussions in an upcoming Board Meeting to assess capital allocation strategies going forward. Finally, we feel very comfortable with our debt restructuring and our credit metrics, our leverage ratio is now in the low twos and we have an FFO-to-debt ratio in the low to mid-30s. Both of which are better than the median within the Class 1 sector and better than all of the BBB+ rated rails. This provides us ample financial flexibility for future capital allocation strategies. And with that, I’ll turn the call back over to Pat.

Okay, thanks, Mike. Before I open the call to questions, I just wanted to comment on a few topics that I believe will be on your list of potential questions. First is, NAFTA and I already talked about this to some degree in the opening comments and Jeff did as well. We are very pleased by the publication earlier this week from the US Trade representative with a list of priorities. I don’t see any significant concerns with that document. The reaction in Mexico appears to have been positive as well. But we are not completely out of the woods yet. All indications are positive and as you all probably know, the process moves forward with the private negotiations taking place beginning in the middle of August. COFECE, the anti-trust second topic, anti-trust investigation in Mexico really not much new since our earlier statement. There is a very good disclosure in our 10-Q which will be published later this morning and that’s really about all we are prepared to say on that since the investigation is still ongoing. So I would advise you not to waste your precious time with questions on that topic. Share repurchase, as Mike mentioned, we’ve completed the $500 million program that we had authorized and we are going to continue discussions with our Board. As Mike mentioned, we have four new Board members. We thought it was proper to include them in the discussion and we will do that at our next Board Meeting and advice after that discussion. And then finally, just picking up on that, the Board’s constitution, as you saw a press release in May, I think May 30th, we’ve added four new directors, which we feel add considerable expertise, business acumen, leadership and diversity to our Board. As our Chairman Bob Druten stated in that May 30th press release, these four new directors complement and enhance the skill sets of our current directors and put us in very good shape from a Board strength perspective for the years ahead. So with that, I will open it up to questions and see what’s on your mind.

[Operator Instructions] Thank you. Our first question comes from the line of Allison Landry with Credit Suisse. Please proceed with your question.

Thanks, good morning. So, cross border intermodal volumes in the second quarter recorded the highest in absolute terms that you’ve ever moved and even year-over-year and sequential changes were very strong. Assuming this is largely a result of the new service with BNFS, how should we think about the incremental growth in the second half? And then, more importantly, where could we see that 2.5% market share that you had at the end of 2016 at cross border. Where could that go in the next two to three years?

Thanks, Allison. I’ll take this. This is Brian. Obviously, we are very pleased with the results of the new service. It certainly is impacting us from a cross border perspective. We continue to believe it’s going to grow. Obviously, the largest opportunity is truck conversion to rail. And so, we are completely focused on that. I think, it’s important to go back to the slide where we talked about the number of IMCs that are now moving on that service as well the service with the UP and the diversity that we have from a box perspective. We see that business continuing to grow. How high will it grow, how far will it go will really depend on how much we are able to convert off of truck. We feel like we’ve had a great season if you will in the bid processes and we look forward to the growth that’s going to happen. But I think you will see, it will continue to grow and I think as Jeff mentioned, the service continues to provide consistency and something that customers couldn’t depend on. So, we are excited about the growth and I think it’s going to continue into the next year, year-and-a-half significantly at the rate that you see.

Okay, thanks. That’s helpful. And I apologize if I missed this from the comment before, but could you guys give a core pricing number in the quarter?

We did not. But is going to be – I am going to say mid to low single-digits. We are very pleased with that and we are going to continue to see core pricing where it needs to be. It’s very similar. We want to be inflation plus and we are continuing to see that.

Yes, I would say, it’s Mike. 3% was our same-store sales and our renewals were a little bit higher than that.

Okay, is that consistent with what you saw in the first quarter?

Yes.

Yes.

Okay, got it. Thank you.

Thank you. Our next question comes from the line of Brian Konigsberg with Vertical Research Partners. Please proceed with your question.

Yes, hi, good morning.

Good morning.

I just wanted to ask about, with the movements of the peso, I imagine that your service is becoming a bit more competitive in Mexico versus truck. I just want to get your view on how that might impact your intermodal into the second half?

Brian, thanks. The only thing I can tell you is, we are very pleased with the way the peso is moving. But you really, we are going to have to see still a number of points from a peso reduction before we are going to be able to be completely competitive. It certainly helps us in certain markets and allows us to move forward in those markets, but, obviously, truck pricing is going to be very, very competitive and so you get back around the 2015 type environment from a peso perspective. So, that’s kind of where we sit.

Brian, this is Mike. I think we’ve always said that Lázaro is probably the perfect place where we will stand what happens, because of currency and thoroughly we’ve lost some share there over the last two to three years as the peso slid, what almost 22 earlier this year. Now, back at 17.5. We have seen growth return to Lázaro and as Brian mentioned, some new bookings that we’re excited about. So, hopefully that that currency, it’s always hard to isolate it to one single factor, but god bless our intermodal team that’s had to deal with this currency for the last few years, but hopefully, we will see that accelerate now in growth.

Great. And maybe just following up on just Lázaro on just with the APM terminal and that ramping up maybe some updated thoughts on how that progresses into the second half and maybe into next year. If you could quantify anything that would be great?

Brian, what I would say is the Lázaro terminal is now moving freight. We are seeing excellent growth. Obviously, there is a lot of share shift going down there with the terminal providers and so, we are really going to see that that improvement is going to be in the second half as the retail season in Mexico kicks in, looking at the cross border bids that have occurred, you will see those more in the first quarter of 2018. So, we are going to continue to see the ramp up here over the next six, nine months. But we are excited about both of those terminals and the servicing that we are seeking from them. So it’s a good space right now in Lázaro.

This is Pat. I just like to provide a little other kind of color commentary on the intermodal and the pricing in the peso. You got to remember and I think we’ve talked about this on our previous earnings call. Our piece of the move is a relatively small portion of the cost of the total move, just take North China to Mexico City, we are charging hundreds of dollars. That move is thousands of dollars and for the most part, that business is US dollar based. So, our customer, the ocean carrier and the beneficial owner are paying in dollars and the savings that they can incur because of the weakness of the peso at today’s level is literally in the tens of dollars. We offer a security advantage versus truck, a safety, security, cargo security. So, the magnitude of the savings if you will, that our customers can enjoy at today’s currency levels versus the security aspect and just put an example to it, if you lose one container filled with flat screen TVs, you have eliminated interest savings on hundreds or maybe thousands of containers by going to cheaper truck. So it’s important to kind of put this in perspective that for the ocean carrier and the beneficial owner, the savings that they can get from the currency at today’s level, at 22 or 23, it’s a little bit bigger, but at today’s level it’s insignificant versus the security features of rail.

Thank you. Our next question comes from the line of Scott Group with Wolfe Research. Please proceed with your question.

Hey thanks.

Good morning, Scott.

Morning guys. So, really strong yields in the quarter and it looks like mix was a big help. Is there any way to kind of help us, I know, mix is a tough one, but is there any way to kind of help us think about kind of the pace of either total yields growth or mix, given your volume outlook for the back half of the year? I am thinking about going forward.

Yes, Scott, what I would tell you is, I think that, we are continuing to see growth in all of our major lines of business. And so when you think about yield and how the pricing and overall items that would drive both revenue per unit and earnings growth, we are seeing benefits in almost every single one of our business units. So, it’s linked to haul. It’s pricing. And it is volume. Some of these are really moving forward the energy segment obviously. So, across all the units, across all of the elements that you would expect to drive yield, we are seeing strength in each one of those.

So, meaning, it looks like mix was – I don’t know, 400, 500 basis points help in the second quarter. Are you saying you think that’s kind of a sustainable tailwind into the back half of the year given the volume outlook that you guys have?

Yes.

Okay.

Scott, this is Mike. Obviously, we are not going to see core growth like we did in the second quarter, that’s maybe stating the obvious, I think crude could come down a little bit in growth. It’s always hard to project as from a mix perspective, but the utility coal and crude are about average RPU segments for us. I think where you could see some continued growth would be in the refined product area and petroleum because of the length of the hauls typically did better mix story for us. So, those are the couple of puts and takes.

I would also say that intermodal yields as a revenue and profitability per train will be a contributing factor even though people tend to think that intermodal is low yielding because of revenue per unit. But when you consider the capacity that we have particularly with the new service, every container that we add and as we complete, as we build out the density on those trains and that service, as we achieve greater balance north bound and south bound, the margin improvement on that service could be significant.

Thank you. Our next question comes from the line of Tom Wadewitz with UBS. Please proceed with your question.

Good morning. I wanted to – so if you could expand on that a little bit further, Pat just in terms of where are you at with the bound to northern service on intermodal in terms of containers per train and how far along you are in a way that’s built out and I don’t know if you have thoughts on that more broadly across the intermodal business in terms of we add on train length and where do you think that can go to, because obviously that can be a nice contributor to incremental margin profitability?

I am going to take a first shot at it and Brian can add some color, but I’d start by saying I am going to give you a fairly unsatisfying answer in terms of specifics, in terms of number of containers. I will say, we are ahead of where we expect it to be after just a few months. So it’s growing faster. We and BN and the customers are very pleased with the service. And we are – I’ll say, we are probably about 50%, maybe even less than 50% of where we could be if we ran an ideal density and balance type of network.

Okay, I am going to give you another one that you may provide an unsatisfying answer or maybe you’ll get by the time. That was a fine answer. That was helpful. I appreciate that.

We won’t respond by saying, it may not be a very fast lying answer, but it’s the answer we are going to give you.

Right, right. I understand. Refined products, you’ve seen a pretty significant ramp in that and it would seem like there is a way to go. So if you have 5000 carloads to that in the second quarter, whatever the number was for second quarter for refined products to Mexico, is there a way to put - providing a ballpark for what can that be in third quarter, fourth quarter or if that’s too near-term? What kind of a runrate can you achieve when you look at 2018 and some of this – more of these unit train terminals have come online and you got more time for people to ramp up. Just kind of a broader way of thinking about it.

Yes, this is Brian again. What I would tell you is, it’s difficult to put a number on it obviously in the short-term. I have so many of the terminals that are under construction. Again, we will go through those stats, U.S. has a 90 day supply. Mexico has a 2.5 day supply. So, when you think about the mammoth stores that have to be built out, the lines that have to be really connecting those, those particular storage facilities, we got a long way to go. But we are going to continue to see growth and significant growth as these facilities come on not only in the second half, but into 2018. There are a number of players both on the origin and destination side that are under construction. And so, you are going to continue to see pretty significant growth in these refined products, especially LPGs and the unleaded fuel here in the next 12 months.

Thank you. Our next question comes from the line of Chris Wetherbee with Citigroup. Please proceed with your question.

Thanks. Good morning.

Hi, Chris.

Hey. I wanted to ask a little bit on the volume outlook for the second half of the year. So, just comparing that’s where you were a quarter ago, it looks like, you are in the high 80s in terms of neutral or favorable sort of commodity groups versus, I guess about basically the entire business last time. So just wanted to get a sense of maybe how we think about this cadence going into the back half of the year? Clearly, there was very good growth in the first half. Just want to get a sense of maybe if you could help us with some of those end-markets and how we should be thinking about the growth?

Yes, I think, Chris, the perfect answer to that was, Mike, when he came in and said, we don’t believe or going to continue to see the growth in the energy market that we saw in the first half. But we are very happy with the sequential growth and it’s going to continue to stay strong as just when you look at the comps, that’s going to be a little bit different. When you think about the Ag market again, it continues to grow at the same pace that we thought it would. All the other businesses that we thought would be favorable or going to continue to be favorable, but again this look on that page is very much second half focus and that’s where that energy market is just kind of leveling out. We are starting to get into our groove if you will there from a volume perspective. And really the only negative that we have there is, the industrial consumer and that’s just the continued focus on price in the paper and steel markets. So, we feel really good about all the markets we are in.

Okay, okay, that’s helpful. And then, when you think about refined products, I guess this is a two-part question, when I look at the slide that kind of highlights the quarter-to-date revenue in carloads. It looks like June maybe took a slight pause relative to May. So just wanted to get some color around that and then sort of in connection with the investment you are making down in Mexico and terminals, do you need to see more investment before that really starts to ramp up in the second half of this year maybe 2018?

Yes, I think, I would say that, you are going to continue to see more investments. So there is going to be investment in tracks, terminals, Jeff talks about the facilities at Sanchez that are going to support some of this volume. So you are going to continue to see that. So, as those investments are made, you are going to continue to see volumes grow. What I say May, or June, it is lower or higher, in reality, we continue to see it moving higher each month. Whether there is a timing difference on when shipments move, and I mean, you know train volumes and they are relatively low right now. So, one train and the train and that could make a difference. But what we are seeing is continued growth across all of those segments that we are supporting into next year, certainly as we get to the end of 2017, we are going to continue to see that growth.

Chris, this is Mike. Obviously, three weeks in July doesn’t make for a month or a quarter, but we’ve seen a significant ramp in the month of July.

Thank you. Our next question comes from the line of Justin Long with Stephens, Inc. Please proceed with your question.

Thanks, good morning and congrats on the quarter.

Thank you.

Thanks, Justin.

So, I was wondering if you could talk a little bit more about your capital deployment strategy as it relates to refined products in Mexico, now that this business has started to ramp pretty significantly. Have you thought more about the amount of capital you’d be willing to allocate towards this opportunity and as you think about the returns, are you viewing this as a – something like a five year investment given the potential for pipelines longer-term or do you think, you can still generate a return over a – call it, five year timeframe?

Yes, Justin, what I would say is, we are continuing to look at a number of key investments. We think we are going to continue to see ourselves as well as others investing in terminals that are going to drive the volume necessary. When we look at the competition with pipelines and others, it’s important to remember a pipeline is going to require the same type of real estate purchases and things that we have in the railroad environment and so, it takes a number of years. We think we are probably at least two to three years out in front of anybody else in this space and by developing these terminals that I mentioned, with the high density able to take both trans load and storage. We think we have a pretty significant advantage. So, we are going to start to see the returns immediately as soon as these terminals are open. Our terminal down in SOP is now open for business. And so, as we start moving products through those, we are going to see returns I think immediately and we are excited about the other opportunities we are looking at as well. So, it’s a good place to be right now in this refined market.

Okay, great. And secondly, and this is probably one for Mike. I think you’ve talked previously about incremental margins being in that 50% to 55% range on average as volumes grow. But, do you think about all the moving pieces in the business right now? And the favorable mix that you are seeing especially in refined products, is the near-term incremental margin profile likely to be better than that range?

Again, our long stated goal has been to have incremental margins above 50% and every quarter things pop up in the quarter that could impact that positively or negatively. So I’d make that statement over an annual period and we are happy with where our incremental margins are and our goal is obviously to continue to drive those up through the rest of the year.

Thank you. Our next question comes from the line of Jason Seidl with Cowen and Company. Please proceed with your question.

Thank you, operator. Good morning everybody.

Good morning, Jason.

Couple quick ones here. I guess, one, I’ll piggy back on another question. You guys mentioned the service with the BNSF is not anywhere near ideal density and/or lane balances. When do you expect to get towards that ideal level and what’s going to get you there?

Yes, it’s business.

Jason, I would tell you, we are right on and actually ahead of where we thought we would be. All of the partners that are engaged in this obviously it’s a number of railroads, IMCs. Everybody is completely focused on this. We’ve always said it will be the consistency of service that drive people towards this. The bid cycles of these are February and so, from our perspective, we are going to have a great second half in the intermodal business. We are going to do better in the bid cycles next year, because people are going to get used to it. They are going to trust the service and so, it’s going to continue to grow. But it takes time. People have to depend on this service. It’s important and I think Jeff and his team have done a great job of giving us that consistency.

Okay.

We will let you have a follow-up question here, but, I hope nothing, we said earlier suggest that we are disappointed. I think the way you phrase the question, we are very pleased with this. It’s ahead of schedule and we didn’t expect it to fill up the train in just a few months. And I think, go back to Brian the math and the discussion that Brian showed in the presentation and I hope everyone understand the significance of where we are at strategically with our intermodal product. We literally can provide intermodal service to any connecting carrier, container solution, IMC, and major market in the country. So, as you know, some of the U.S. railroads and IMC companies are strategically linked. So, now we have options for anyone and everyone regardless of what IMC and what railroad and what market you want to go to, to connect Mexico. So, we should be very well positioned to see growth in market share in this business for many years to come.

Pat, the question was more of trying to understand when we should start seeing margin improvements as opposed to thinking you guys are disappointed. Turning to pricing, you said you are basically were about the same level as you were in 1Q in terms of same-store. But I noted in your commentary that you are starting to sign new deals at higher levels. What’s sort of driving that ramp up in pricing power in your opinion?

Yes, Jason, this is Mike. I said, renewals were a little bit higher, slightly higher and please understand, renewals, you are not renewing your entire book of business in one quarter and it was only about 10% of our book of business that renewed in the second quarter. So, I want to - maybe tamper your enthusiasm. We are obviously going to look for driving price based on the value that we are providing to our customer base. But we think the pricing environment is about the same that we’ve seen over the last three or four quarters.

Thank you. Our next question comes from the line of Brandon Oglenski with Barclays. Please proceed with your question.

Hey, good morning everyone and thanks for taking my question. Sorry, did I got a little bit distracted as we gone through the Q&A. So if I am asking the duplicative question, I apologize you again. Maybe that won’t be a great question for you. But, where do we see the margins long-term in this business guys? I mean, we’ve been talking about getting to the low 60s and why you are there this year. Is there a lot of room for improvement on the efficiency side as you ramp up some of these investments you guys are making over the last several years?

Yes, I’ll take that one and maybe let Jeff to comment. I mean, we still see opportunities for operational improvement obviously. Volume and the pricing environment we are in will be helpful and contribute to further margin improvement, but there is also – the harder work of continuing to improve and refine the way we run the railroad and I think, I am glad, we got the opportunity as Jeff to chime in here, because that’s where we really saw significant improvements, particularly in some of the Northern Mexico, but really across the network during the quarter. Jeff, I don’t know if you want to comment.

No, again we are continuing to focus on the main drivers equipment, asset utilization. I think we saw some nice improvement in cycle times here in Mexico which is heavily dependent on the car hire numbers. So I think we saw some nice benefit in the quarter for that. Locomotive, if we – you see we’ve got the – we are at the same number of locomotives in storage that we had last quarter with about 5% sequential growth. So that suggests we are continuing to gain efficiencies there. Probably some opportunities we are going to start looking at our low – our switching. I think we’ve got some additional room for consolidation and things like that. So we are continuing to focus on all the key drivers and I see there is still room to go.

Yes, and I am sorry, Pat and Jeff, they have might not been a very satisfying question. But if your western peers though who out there that say, hey look, we can get to a 55 and you know that there is a lot of discussion on what CFX is going to with Mr. Harrison. And is there any reason to believe that, a shorter length of haul business like yours can’t get to those levels or should we be thinking long-term, it’s all kind of the same?

I’ll put it this way. There is no reason and we certainly don’t feel that we can’t keep pace with the rest of the industry. Obviously, we don’t have the length of haul. But we’ve got other things that we have to use as levers to improve profitability. But I will also say, and you’ve seen this and if you have watched our change in compensation philosophy. And in some of the metrics we are using as we get down to a 60 operating ratio, it becomes a little more important to look at sort of balanced set of metrics including cash flow and return on invested capital and an increase in earnings per share and we – not to suggest by any stretch that we have declared victory or we will declare victory on operating ratio. But it really becomes more of a question of what are the main drivers that shareholders are interested in and when you get to a certain operating ratio level, this will become more important to look at different metrics that will drive shareholder value.

Yes, this is Mike. I’ll just make one additional comment. If you work your way through our numbers this quarter and just look at the revenue growth and the kind of bottom-line contribution that had, I’ll take that revenue growth any quarter.

Thank you. Our next question comes from the line of Bascome Majors with Susquehanna International Group. Please proceed with your question.

Yes, if you go back and look a few years ago, the KSU story, free cash flow wasn’t super high on the list of readers to own the stock. But that has changed quite a bit and looks like it has a potential to continue to change very much in a positive direction over the next few years as your CapEx comes down and if we have economic growth to grow the business on top of that. I am just curious, as we kind of look at that trajectory of free cash flow versus earnings over the next, two, three, four years, were there any offsets we should think about before we get too carried away?

Bascome, this is Mike. I would agree with all of your suggestions about where free cash flow will go. The only thing that will be a little bit different going forward and it’s tough to anticipate right now exactly when that would happen would be cash taxes in the U.S. We are not currently a cash tax payer. We would expect to at some point in time. But with bonus depreciation, we are really in place for the next couple of years, we feel good about our ability not to be a cash tax payer and then if tax reform is enacted, we’ll just have to see what the impacts are there. But, at least over the next couple of years, we would not anticipate any kind of significant step-up in the cash taxpaying status in the U.S. We are in Mexico.

Well, if, kind of drilling down on that a little bit, assuming that nothing happens on the tax reform front just federal law continuing as is, roughly when, based on your projections would that shift to taxpaying in the U.S. happen? And if you could give us a sense of kind of the delta that might have on your cash tax rate?

I’ll say, as far out as we possibly can push it and no, I won’t go through any of those details because I think there are too many variables that stake a couple of years out to give you any credible estimates on that.

Thank you. Our next question comes from the line of Brian Ossenbeck with JP Morgan. Please proceed with your question.

Hey, good morning. Thanks for getting me in here at the end.

Good morning.

Just to, Brian for you and then maybe for Jose, just anymore details on the SOP terminal? You mentioned the $20 million of spending coming up, it’s open for business, but clearly in the numbers it’s not really generating too much volume yet. So, if you could just give us a sense of how that is ramping up and perhaps what sort of customer interest you are getting in? And which type of customers those might be if it’s from people who are establishing their own brands, like the Exxons of the world or if you have some kind of internal domestic players in Mexico as well?

Sure, Brian. What I would tell you, is SOP is open for business in trans business, so that means directly from rail to truck. The storage part of that facility will be coming here in the near future and the important part of the customer base is obviously I can’t give you the names of the people that are interested in that, but we have high interest from, I would tell you two main groups. The suppliers of refined products in the Mexico which are primarily those who have the refined products already in the U.S. and Gulf Coast and then the distributors who actually will receive the product from that facility. Without storage you kind of have to have a very specific relationship, rail to truck ratio. And that’s really where we are working. But what I would tell you is we are open for trans business and expect to be open for storage business as quickly as things can happen down there that allows to get the storage built quickly. But that’s usually about a nine month process to get a tank built. So, that gives you a little bit of a range.

Okay, so probably by end of – year end would be a reasonable expectation?

Well, you’ll see volumes into that facility for all of the second half and much higher volumes into 2018 as you have the storage available.

Right, I was referring to this storage coming online.

Yes, 2018, certainly.

Okay. And then, just a follow-up one on PTC. The ramp up of the expenses are certainly helpful. I was wondering if you could put some context around – you said there is some headcount in the quarter Jeff, so, how much was that and how much more do you think is coming into the future and sort of your initial impressions of revenue service testing, six sub-divisions, I mean where do you have to go? What are you seeing anything, positive, negative, that’s coming out of the early phase of that test? Thanks.

So, this is Jeff. The actual financial impact might get – of course in corporate, those headcount assumptions. I think the number was around 20, 25 for the total, just absolute number of heads added. PTC, again I said we are on schedule as an industry to be installed on our own network in 2018 and they continue to work through 2020 in operability and things. So, as we roll into revenue service, again, I just highlighted that, we’ve got a pretty aggressive rollout schedule, pretty aggressive timeframe which I think we are okay to achieve and are on target to achieve. But I kind of added that additional demand. I am pleased with what we’ve done with locomotive fleet and again sequentially, we’ve really held locomotives flat with the volume increase. It could be a little more pressure on a few more locomotives as we work out bucks to the revenue service testing. But nothing I would think significant either way at this point. As we really ramp up in the next quarter, we will have more of an indication on actual impacts.

Thank you. Our next question comes from the line of Ken Hoexter with Merrill Lynch. Please proceed with your question.

Great. Thanks for the run on the energy side. Just a question on your just – guess, Sasol and Autos. Any change on the timing and maybe if you can talk about scale what we should anticipate on that as we move through 2017 and into 2018?

Ken, I think you cut out just a little bit.

Yes.

What was the question about auto?

Well, just I was starting on Sasol on the timing and scale of that. When we should anticipate that coming online and then the auto was just – any change to the plans that are coming on, I guess, BMW is next up and then Mercedes Infiniti. There has been no change to those schedules right?

No change at all. Obviously, Sasol will be completed just said by the end of the year with our portion. We will begin to use that yard. Sasol comes on probably July 2018 is their plan that they have announced and so, no changes on that front. Automotive, all of the plans are proceeding forward. We are right in the middle of a couple of bids for the new facilities. So we feel comfortable with where we are at from a timing perspective, but no, everything is still onboard as we’re on the path.

And Pat, I know you said, not to waste the valuable question on the whitepaper, but since nobody is at, any – maybe you can talk about the timing, not the process, obviously, the process you highlighted in the document, but anything on the timing. Has any of that changed? Or can you walk us through what we should expect in terms of the timing for that?

I think the timing that we still expect the final revolution to be sometime in December. But that’s really all we know. We’ve changed, again, I’ll draw your attention to Page 15 of our 10-Q which will be outlier today with a pretty good disclosure on what has happened there. It’s not earth shattering, we are just waiting for the final conclusion.

Thank you. Our next question comes from the line of Jeffrey Kauffman with Aegis Capital. Please proceed with your question.

Thank you very much. Just a quick question for Mike. Mike, given the changes we’ve seen in currency as of late at the forward forecast that you have listed in your presentation. Does this change your view at all for tax rate in the second half of the year? Or how we should think about it heading into 2018?

It would not change our view around the adjusted tax rate that we referred. Obviously, if you look at the appendix in Slide 27, you can see the reported effective tax rate is quite a bit higher, because of the improvement in the peso. But the adjusted is fairly consistent on a year-over-year basis. We were 34.6 in the second quarter of this year and 33.7 a year ago. So I would continue to guide you about 34%.

Okay. My other questions have been answered. Thanks guys.

All right. Thank you.

Thank you. Our next question comes from the line of Tyler Brown with Raymond James. Please proceed with your question.

Hey, good morning.

Good morning, Tyler.

Hey, Pat. This is a bit of a less field question, but I’d like to ask maybe about a Dave – in favor with the PCRC. So, there is clearly been some short line properties here in the U.S. with very solid port – stories that have sold at high multiples. It looks like the PCRC maybe contributes 2% to pretax income. I mean, would you and your partner ever look to shop that property? Or do you consider it strategic?

There has been no discussions about shopping that property. It runs very well. It requires, Tom Cana who is the President, does a terrific job. He requires very little supervision and effort on the part of us and our partner. So we are happy with it. It’s a great business model and we’ve had no discussions about shopping it. As your second question, other than the fact that we do have some common customers, it obviously doesn’t connect to our – or the rest of our network. So, I would not say that it’s terribly strategic. That it’s a nice performing asset that requires very little intervention and effort from Kansas City.

Okay, that’s helpful. And then Mike, from a balance sheet perspective, you guys call it, have – call it, sub-two times debt-to-EBITDA. It seems like the agencies are unwilling to reward you for the ratios and you’ve got a number of heavy capital projects that are going to sunset. So would it ever make sense to maybe lever up a bit, take advantage in the stock? Is that something you and the Board have kind of discussed?

Well, we are having ongoing discussions with the agencies, but I am sure you can appreciate that’s like a snail moving through peanut butter. We are having discussions with our Board coming up. But we are not in a position right now to indicate when we are or how we would handle that.

Thank you.

So we see no further questions in the queue and there is no better way to end this call than the visualization of a snail moving through peanut butter. So, thank you for your attention. Again, we feel great about the quarter, solid and clean. I think that describes how we feel about it, momentum, particularly in some of the new business areas like refined products, the new intermodal service, the plastics, the APM terminal, Lazaro, all sort of coming together the way we had hoped and envisioned. And some of the storm clouds that have darkened our horizon seem to be going away. So, thank you for your attention and we will do this again in about 90 days. All right, bye, bye.

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