Canadian Pacific Kansas City Ltd. (CP) Q4 2018 Earnings Report, Transcript and Summary

Greetings. And welcome to the Kansas City Southern Fourth Quarter and Full Year 2018 Earnings Call. At this time, all participants will be 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 the 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, 2018, 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.

Okay. Thank you. Good morning, everyone, and Happy New Year. I will start on Slide five or Slide four, I am sorry, with the presenters. And you will see one change in our line-up this quarter. Mike Naatz is going to be speaking to the sales and marketing and revenue side of the business in the presentation. We also have José Zozaya on the phone in Mexico; and Brian Hancock is here in the room with us for Q&A. Moving to Slide five, fourth quarter results, revenue increased 5% to a record for the fourth quarter, $694 million led by strength in crude oil and refined products into Mexico. Volumes were flat from the previous year. Fourth quarter operating ratio was 63.1%, adjusted operating ratio is 64.3%. Mike Upchurch will get into details about the adjustment, but basically it relates to insurance recoveries from the Hurricane Harvey flooding in 2017. Fourth quarter earnings per share of $1.59, adjusted earnings per share of $1.56, which was a record for the fourth quarter and 13% improvement over last year. Slide six, we are going to talk about the full year results. Revenue increased 5% from 2017 to a record $2.714 billion, 2% volume growth. Full year operating ratio reported as 63.7%. Again, the adjustment takes that to 64.3%, with the adjustment primarily being the insurance recovery that I mentioned a minute ago. Full year EPS of $6.13, adjusted to $5.97, which was also a record and a 14% increase from 2017. Slide seven, probably the most interesting slide in the presentation today. We have finished our full year 2019 plan and long-range plan update, and keeping with our commitment that we made in November of sharing -- being a little more forthcoming with guidance, this is where we ended up when we finished our planning process. For 2019, we are looking at volume growth in the 3% to 4% range, revenue growth of 5% to 7% for 2019 and we are putting a longer term operating ratio target out there of 60% to 61% by 2021. Jeff will talk more about that. We mentioned -- and you saw in the press release, we mentioned a heightened focus on operational excellence and operational performance, and implementation of some of the principles of Precision Scheduled Railroading. Jeff will get into that in more detail in a few minutes. I will just say that we are in the very early stages of our work and understanding how PSR principles will apply and we will, probably, not be completing in terms of answering some questions about timing and magnitude of some of the details. Again, we are very early in our thinking here. So further guidance here, earnings per share over the next three years low to mid-teen compound annual growth rate and EPS. And CapEx for 2019, we are looking at the $640 million to $660 million range -- $660 million, which includes some locomotive purchases that we have talked about in previous reports. And then beyond 2019, we are looking to CapEx migrating down to something in the high-teens but below 20%. So, with that, I will turn the presentation over to Jeff.

Thanks, Pat. Good morning. Starting with review of operating metrics for the quarter on slide nine, overall dwell on velocity showed general improvement over Q3. Peak third quarter congestion eased in December and January year-to-date metrics continued to show improvement. Coming out of our normal holiday slowdown period, last week’s reported dwell has returned to normal levels at 22.5 hours. Expanding on the current state of operations on slide 10, other key metrics showing substantial improvement are the terminal performance at Monterrey and Sanchez. Inventory and dwell at these terminals have significantly improved since peak levels in the third quarter. We continue to work with customers to right-size equipment and optimize service in this region. Cross-border initiatives continue to support fluidity in the region and Q4 was another strong quarter for cross-border volume that increased by 16%. We continue to progress our international crew initiatives and are seeing a reduction in overall transit time across the bridge as more trains operate with this crew base. Turning to Slide 11, I will provide a quick update on capital spend. 2018 capital was 19% of revenue or 5% below guidance, reductions attributed primarily to cost savings in PTC and other capacity projects coming in below budget. Highlights for 2019 capital include continued investment in cross-border line of road capacity and infrastructure improvements to support the growth in this region. Segments between Houston and the border, as well as Monterrey to Matamoros continue to be a priority to support cross -- strong cross-border demand and new refined products terminal coming online in Houston and Gulf regions. Additionally, we are on track to receive the first of 50 new higher horsepower locomotives units late in January. As mentioned last quarter, we are selling 33 lower horsepower units as part of this transaction. I will provide additional color on our locomotive fleet momentarily. Turning to slide 12, I would like to provide some insight into our plans for PSR. Entering 2019 we are focused on implementing the PSR operating principles that are most relevant to our network. To assist in this process we have entered into a consulting agreement with Sammy Fanny [ph]. Mr. Fanny is a former Canadian National Executive with 27 years of experience at CN, 12 of those years spent working as part of Hunter Harrison’s Executive Management team. In addition to his experience with CN, Mr. Fanny has done work with other railroads in similar PSR roles. He also brings a wealth of locomotive knowledge as he worked with GE for three years. The initial areas of focus include improved labor and asset utilization, trains start rationalization and fueling efficiency among several others. Mr. Fanny’s compensation structure is in line with that of our executive management team and we are all working toward shared financial goals. Providing some real life examples of recent initiatives, we have redesigned our Intermodal and manifest product between Kansas City and St. Louis, and have reduced eight train starts per week in this segment. Initial rationalization of our Mexico network has provided an additional 28 train start per week reduction. Combined, these two initiatives will save over $2 million per year in labor cost alone in addition to locomotive, fuel and equipment savings. Turning back to our locomotive strategy, PSR initiatives will allow us to reduce the overall locomotive fleet. While we have not identified a total number for reduction at this time, as compared to the peak number of active locomotives in 2018, we have returned 25 leased units and are in process of [storing] [ph] an additional 20 units. Acquisition of the 15 new units is in line with another of our PSR initiatives of reducing locomotive failures. New reliable units will allow for increased fleet utilization by reducing unplanned failures. At the same time, this acquisition provides additional high horsepower units to support the growth in our refined products unit train segment. We will continue to target other yard, local and poor performing road units for disposition. Nothing about our networks should prevent implementing parts of PSR that will help drive efficiencies and we will continue to work closely with interchange partners who are also at work on PSR initiatives. In the end, we look to see more efficient interchanges from overall rail network improvements. I will now turn the presentation over to Mike Naatz.

Thank you, Jeff, and good morning, everyone. I will start my comments on page 14. You will see the fourth quarter year-over-year revenue was up 5% on flat volumes. If you were to look at the appendix, you’d see full year revenue and volume growth were at 5% and 2%, respectively. In the fourth quarter, we continue to see strong growth in cross-border carloads and revenue, most notably from refined products and cross, excuse me, cross-border Intermodal business. However, as Jeff discussed, during the first half of Q4, we were challenged by congestion in Northern Mexico and this did have an impact on our business. During the quarter, our revenue per unit grew consistently with what we experienced in Q3, despite mixed pressure from the loss of some long-haul utility coal business and unfavorable FX. Core pricing environment remains healthy and we expect pricing to outpace inflation. The Chemical and Petroleum business unit reported revenue growth of 19%. This growth was primarily driven by strong southbound volumes of refined products moving into Mexico. For the full year, Mexican energy reform business contributed nearly $100 million of revenue with carloads and revenue growing at 156% and 120%, respectively. We included a full year recap on this topic in the appendix. It’s also worth mentioning that plastics grew at 14%. Revenue from our Industrial and Consumer business unit was down 5% year-over-year. This decrease was primarily attributable to timing of military moves, a shift in a customer sourcing location within our metals business, which in turn significantly reduced the length of haul in those moves and then the previously mentioned congestion at the border. Revenue in our Ag and Min business grew at 8% in the fourth quarter. This growth was driven primarily by our grain business due to improvements in cycle times and we did see positive pricing gains. The energy unit’s revenue decline of 7% was driven by a previously announced closure of a power generation facility in Texas and by continuing declines in frac sand. These declines were partially offset by higher volume and pricing in our crude oil business, driven largely by Canadian crude shipments. Intermodal revenue increased slightly year-over-year with mixed performance by lane. The cross-border franchise revenue growth was solid at 8%, driven by truck-to-rail conversions. Other domestic lanes were challenged by congestion and tougher year-over-year comps. Additionally, while Lázaro Intermodal volumes declined 5% year-over-year, we did see meaningful sequential improvement in this lane driven by our actions taken to restore our Lázaro Cárdenas volumes. Revenue from the Automotive business was down slightly over the prior year. Border congestion, unplanned plant shutdowns and continued equipment availability issues in North America impacted this business unit. And now I’d like to move on to slide 15, where we provide a business segment outlook for 2019. As Pat mentioned, our full year volume outlook is approximately 3% to 4%, with a 5% to 7% year-over-year revenue growth projection. Starting with the Chemical and Petroleum business, the Mexico energy reform continues to be a significant focus and unique opportunity for KCS. We expect volume growth from refined products to continue next year, as demand increases and storage capacity comes online. We expect Plastics to grow in 2019 with increased demand. Additionally, heavy fuel oil shipments in Mexico are also expected to grow along with higher production. We expect to see solid performance in the Automotive business, even though certain plant closures were unexpectedly elongated following the holidays. We expect volume to grow slightly ahead of most third-party estimates for Mexico production. In addition to increasing production to Mexico, volume growth may benefit from market share gains, easing congestion and additional equipment. We expect to see continued but moderated growth in our intermodal business at cross-border and U.S. domestic businesses started slowly, but we expect to benefit from truck-to-rail conversions, tight truck capacity and expanding capacity at some key Intermodal terminals. As mentioned earlier, we expect to see positive sequential trends in our Lázaro business as additional trucking regulations are implemented in Mexico and as our customers continue to evaluate and take advantage of our short-term volume-based pricing strategy. However, we are taking a pragmatic approach to the business focusing on strong service product and rational pricing. We believe that this focus will help us deliver future drive volume growth that is both sustainable and in the best interest of our customers and shareholders. As for Energy, our coal business should grow with higher natural gas prices and increased demand in the Texas market. On the crude side of things, we are monitoring developments around mandatory production cuts by the Canadian Government and the corresponding potential implications on our Canadian crude business. Additionally, we expect continued declines in frac sand due to sourcing pattern changes. And lastly, our outlook for Industrial and Consumer and the Ag and Min business is neutral to slightly positive, although our metals business should improve in 2019 due to capacity expansions and improved cycle times. We are watching the impact of changes to the global trading patterns and tariffs very closely. And with that, I will turn things over to CFO, Mike Upchurch.

Thanks, Mike, and good morning, everyone. Let me start my remarks with a summary overview of fourth quarter 2018 results. Revenues of $694 million were up 5% primarily due to higher fuel surcharge revenues. Reported operating ratio improved to 63.1%, predominantly due to an $8.5 million insurance recovery related to Hurricane Harvey. On an adjusted basis, excluding the positive impact from the insurance recovery, our operating ratio was 64.3% slightly worse than 2017. Reported diluted earnings per share for the fourth quarter of 2018 was a $1.59 down from $5.33 in the fourth quarter of 2017, due to the one-time benefits we recorded as a result of Tax Reform. Adjusted diluted earnings per share of a $1.56 was 13% better than fourth quarter of 2017. Our adjusted effective tax rate for the fourth quarter of 2018 was 28.3% and for the full year 2018, 28.9% in line with our guidance of 29%. For 2019 through 2021 we are estimating an adjusted effective tax rate of 29% to 30%, and from a cash tax standpoint we would expect 2019 to be approximately 17% and for 2020 and 2021, 23%. And you will find more details on our tax rates have been included in the appendix on page 31. Turning to operating expenses. Operating expenses in the quarter adjusted for the insurance recovery from our Hurricane Harvey claim increased 6%. Depreciation expense increased $10 million, the result of in-servicing PTC assets and from a general increase in our asset base. Fuel prices increased both in the U.S. and in Mexico driving up fuel expense by $10 million. Equipment costs were down $6 million, driven by lower lease payments from owning more of our equipment and lower car hire. Purchase services were up $4 million due to slightly higher IT, joint facility, dredging and security costs. We also experienced higher personal injury costs in the quarter due to changes in estimates from an actuarial study and experienced the large derailment early in the quarter in Mexico. Wage and benefit inflation and higher headcount of $4 million and $3 million, respectively, was partially offset by lower incentive compensation costs of $3 million. Finally FX lowered overall expense by $5 million. I’d also like to provide you a few thoughts around 2019 expense levels. First, we expect compensation and benefits to increase about 5% due to wage and benefit inflation and slightly higher headcount. But as Jeff mentioned earlier, we also expect to produce labor efficiencies based on our early PSR work. Excluding the credit for insurance settlement, continued materials and other, we would expect M&O expense and purchase services have normal inflationary type expense increases in 2019. We have also included estimated fuel prices for 2019 in the appendix on slide 25 and we currently believe fuel prices will moderate in the U.S., but increase in Mexico and we do expect to continue to be eligible for the fuel excise tax credit in 2019, which we estimate to be $35 million to $40 million. We expect our equipment expenses to be down slightly, as a result of owning more of our equipment and from better cycle times. Depreciation is expected to increase approximately 9% and is inclusive of PTC depreciation headwinds of $13 million. In total, we will see PTC expense increases of approximately $17 million for the full year 2019. Finally, let me cover some of our capital structure and capital allocation priorities. As Jeff mentioned earlier, CapEx is $512 million for 2018, did come in substantially below our original and revised third quarter guidance. We will continue to ensure capital spent in a prudent manner to support our growth. While 2019 capital will increase due to purchasing 50 new locomotives, we would expect capital expenditures to decline both in 2020 and 2021 to levels slightly below 20% of revenue. We continue to repurchase our stock under the $800 million stock repurchase plan approved by our Board in August of 2017. In the quarter, we repurchased $80 million of our common stock, which was approximately 50% ahead of our prior quarterly pace. Cumulatively, we have now repurchased approximately $1 billion of our stock. And finally in October, S&P recognized our improvement in the capital structure and upgraded our credit rating to BBB flat. And with that, I will turn the call back to Pat.

Okay. I think that maybe a record in terms of finishing our formal comments. I will just make a couple of closing remarks before we open it up to questions. I will refer to the statement quote actually in the press release about the results, the quarter, the year. Obviously, not a bad quarter, not a bad year in record performance on a number of levels, but as I said in the press release, while we delivered record revenues, adjusted operating income and adjusted EPS, 2018 did not meet our own expectations for financial and operational performance. In addition, we did not meet the expectations of our customers or share owners particularly in the areas of customer service and growth. So while we feel good about performance and we know we are not altogether pleased, because we know we could have done better. The key points I think from the presentation, I am happy to get into the Q&A, are the service recovery, particularly around the border, where we have experienced the worst congestion over the past few quarters is well underway and we feel good about the performance of the railroad as we head into the new year. The growth opportunities, the oversized growth opportunities that we have been talking about for several of the last few quarters are real and we feel that we have got pretty good transparency on a number of those opportunities and still feel very positive about the growth outlook. And the precision railroading initiative, I think, is off to a good start, I have been very pleased with the engagement of the team, both in the U.S. and Mexico, and with the help of Sammy, I think, we can prioritize some things that will give us pretty quick performance improvement areas and then help us deliver the kind of service that we want to on a sustained basis. So, with that, I will open the microphone for questions.

Thank you. [Operator Instructions] Thank you. The first question today is coming from the line of Justin Long with Stephens. Please proceed with your question.

Thanks and good morning.

Good morning, Justin.

So I wanted to start with a question on the OR guidance for 2021 and I wanted to see if there was any color you could provide on the cadence of margin improvement that you are expecting over the next three years. Is it going to be a consistent pace, are more front-end loaded and then you know along those lines, how much of this improvement is a function of PSR implementation versus operating leverage in the business with volume growth?

Yeah. Justin, this is Mike. Let me take a quick stab at that, obviously, the guidance implies somewhere around 100 to 150 basis point improvement in OR. We think we still have one major headwind going into 2019 and those are the incremental PTC expenses, which are about $17 million. We are very early in the process here of identifying initiatives to reduce expenses. So I would probably guide you to maybe an acceleration as we get into ‘20 and ‘21, and you get the full year benefit of some of those initiatives. So hopefully that helps.

That does. And also wanted to ask about the headcount assumption that’s embedded in that long-term guidance, I think, you said this year up slightly, but how do you expect headcount to trend in 2020 in 2021?

Well, I think, with volume growth that we are expecting this year you know we would typically see a little bit of increase in variable headcount to move that traffic. But again, I think, Jeff mentioned it, and I made a comment on it, we would expect to continue to gain labor efficiencies. Jeff gave some pretty good examples and we are just so early in the process that we are not really fully baking in all of those potential opportunities, we will continue to do that as we move throughout the process, but expect us to try to manage headcount as judiciously as we can.

Okay. I will leave it at that. Thanks for the time.

Okay.

The next question is from the line of Chris Wetherbee with Citi. Please proceed with your questions.

Good morning, Chris.

Hey. Thanks. Good morning, guys. Good morning. I wanted to sort of pick up where we left off there, just sort of coming down to the EPS line, so obviously a CAGR issue in 2021. [Indiscernible] some of the things you are talking about there should we assume that maybe we are on the lower end sort of early in the process so maybe 2019 is on the lower end of that CAGR. Just wanted to get a sense of maybe how you are thinking about it as it drop down to the bottomline, because it sounds like there’s some incremental expenses that need to think about for this year?

Yeah. Chris, this is Mike again. I think that’s a safe assumption. Again I’d point to the step up in PTC expenses as we are now in service on our entire network. So you are going to have a little bit of a further benefit as you get into ‘20 and ‘21. So I think it’s probably reasonable for you to model it that way.

Okay. Okay. That’s helpful. And then, I guess, I wanted to maybe get a sense of the CapEx profile. So elevated year in 2019 as you are bringing some new locomotive on to the network and that sort of step-down below 20%. As we are seeing PSR implemented for some of the other railroads, there’s been a really meaningful draw down in capital spending as a lot of assets gets [hard] [ph]. How should we think about, is it the potential for a little bit further of a step-down or what is the dynamic that might keep you from seeing mid-teens to an upper teens on a percent of revenue for CapEx?

Yeah. This is Jeff. I will talk about that. Maybe the locomotive purchase, I think, I can explain kind of the rationale around that and promoting more high horse power units as we transition all that we will look to continue to [indiscernible] or divest some of our older yard locomotives. I think in general other maintenance such as engineering and maintenance away, I think, those things remain pretty much in line and pretty much steady state. I think the difference probably remains to be other growth opportunities, be it capital investments in various refined products opportunities or similar that I think we are leaving ourselves some room to continue to look at how we invest and then play in that space, more from a growth capacity type scenario.

So, probably, won’t see in that sort of mid-teens is, probably, fair to say that that might be a little bit ambitious, because of the opportunities you have around the topline.

I think that’s right, Chris.

Okay. Thanks very much. Appreciate it.

Okay.

The next question is from the line of Amit Mehrotra with Deutsche Bank. Please proceed with your question.

Excuse me, thanks. Good morning. So the company has put out long-term guidance in the past that has not been met. And even more recently, the volume expectations have not come in nearly as expected. So if you could just help us like what’s different this time? You have this 2021 target there. What’s different in terms of you know accountability or whether it’s conservatism in the planning in terms of how you roll up to the 60 to 61 OR. I think that would just be helpful because a lot of the conversations I have, it’s really some sort of long-term targets maybe met with some skepticism. So I think it would be helpful to just put some context around how you get there and what the robustness or conservatism that you baked into the plan?

Yeah. Amit, this is Mike. I guess the prior guidance that you refer to, I think, what we predominantly missed with that guidance was the energy sector meltdown that we saw in ‘15 and ‘16 that seemed to be the source of the miss that we had. In terms of commitment to those numbers and what we have at stake, these are all numbers that are tied to our incentive compensation plans and as you saw in some of the slides in 2018, we didn’t meet those expectations, and therefore, we had lower incentive compensation. So we are -- all in on these targets and they will be tied to our incentive plans. This compensation committee of the Board of Directors will hold us accountable for.

I’d just say we have completed, as I mentioned at the beginning, we have completed our 2019 budgeting process and update of our three-year plan that, as Mike mentioned, is going to be the basis of our incentive comp targets. And this plan is just based on the best information that we have available at this time, feedback from customers, as we learned in the energy situation that Mike referred to in 2014, 2015. That was also the case. I mean, we met with our largest crude oil shippers in January of, I guess, it was 2015. Looked them in the eye and asked them are you serious about this, is this really what you are planning to move, and they said yes and we built it into our plan and built it into our guidance expectations and it proved to be wrong. So we are always going to have risk in our plan and in the guidance, but we have sanity check this as thoroughly as we can. We have had tight dialogue with our major customers to elevate our visibility into the revenue and volume side, and so we feel that this is grounded in reality and based on the best available information that we have at this time.

Okay. I appreciate you entertaining that question. I know it’s a little bit of a tough question, but I appreciate that. One with respect to the PSR announcement, I was wondering if you could just help us think about what part of the network are you guys going to attack or address first, when Union Pacific did it, it addresses kind of mid-American network, where a lot of the frac sand was moving through and obviously volumes are going down there. Any part of the network do you may actually attack or address for us either through pilot programs or just all-in maybe what some of the volume, you can give us any color that I think would be helpful?

Yeah. This is Jeff. I try to provide a couple tangible examples of -- I would say some low hanging fruit we have already identified. I think as we look at this the Mexico network just due to the complexity or of our Intermodal manifest, you look at train length, you look at service design in Mexico, probably, more specifically related to some of these PSR opportunities and I think that’s where we are really kind of setting the site is that’s our priority from a service design perspective and a train start rationalization. As we have seen and continue to work with customers in the Monterrey area as an example, we have made some good strides climbing out of the congestion here. But also taking that further and we have been able to rationalize some of the equipment directly out of that terminal working closely with those customers. So in the area of train start, that will be our focus Intermodal/manifest product in Mexico more strategically. The locomotive arena I have touched on. So as train starts rationalized, locomotives should follow suit and the cruise and the headcount should start following suit as well. So as we embark on in first inning here, I think, that’s where we see the initial work ongoing and starting to provide the most and quickest benefit.

Okay. And Mike is there any change in the pro forma leverage target for the company as you think about capital structure or no?

No. Nothing that we have officially provided, as you know we are in the low 2s right now. We were very focused on getting that final upgrade to BBB flat and that occurred in the month of October and we feel pretty good about the balance sheet right now. I think it gives us a fair bit of flexibility.

Okay. Thanks so much, guys. Best of luck in the PSR implementation. Appreciate it.

Thank you.

Thanks.

The next question is from the line of Bascome Majors with Susquehanna. Please proceed with your question.

Yeah. I just wanted to follow up a little bit on the PSR conversation. Can you talk a little bit about how long you have been working with the gentleman from CN Consulting arrangement and how particularly he is incentivized and what us -- desirable outcome would be over this timeframe? And just operationally around that could you just remind everyone the percentage of your business that either originates and is terminated on your network versus the carriers that you partner with to either originate or terminate shipments? Thank you.

All right. This is Pat. I will take that one and then maybe ask Jeff to chime in with a little color commentary. First of all, we are not going to get any more specific about the compensation or the arrangement that we have with Sammy other than to say that his performance objectives are very much aligned with the -- with mine. We will all of us here around the table, the executives, management team in terms of long-term performance targets. We started working with him actually in December and he spent quite a bit of time both here in Kansas City and down in Monterey, engaging with the team fully kind of a lot of information sharing, a lot of idea generation and then we kind of formalized an arrangement here just a couple of weeks ago. But as I said in my comments, I set in on not all of those meetings, but many of them and I think the level of engagement and then he was -- I asked him this question just yesterday, how does he feel about the engagement of the team not just the executive team, but down into the organization? And I think he’s very pleased with the enthusiasm and excitement the way this has been embraced. And let’s face it, everybody in this company knows that we can do better. As I said in my comments, we had a pretty decent quarter and a pretty decent year, but none of us are very satisfied with it, because we know we can do better. So I think the level of engagement is very high and I am very optimistic that we are going to see some very tangible -- we already have tangible things that are going to help us get better and drive toward some operational performance improvement in sustainability. As far as your question about interchange, there is a belief out there I know some people have written that maybe PSR doesn’t apply to us because of our size and because of the magnitude of our interchange. We don’t believe that. But we really want to focus on the messages that we are going to adopt and implement principles of PSR that we think are most pleasurable to our network and I think there are a lot of them that do. So a lot of this is just about discipline, focus, accountability all of those kinds of things would certainly apply and we will embrace and implement those things. But the other factor is if all of the other railroads that we interchange with are adopting and implementing certain principles their own version of this, then it makes sense that we need to be aware of and be prepared to engage with our interchange partners differently, and if the result of their effort is more consistent and reliable service to us at the point of interchange, then it kind of follows that we will benefit from the work that the other railroads are doing in this regard as well. I also think it is important to point out and realize that the recent management change at Union Pacific, which is our largest interchange partner particularly at the border Jim, Venna and Sammy worked together side-by-side on the same executive team for a dozen years or more. So, I think, the level of coordination and communication that will have with UP as they continue to implement their own version of PSR will be enhanced.

Thank you.

The next question is from the line of Tom Wadewitz with UBS. Please proceed with your questions.

Yeah. Great. Good morning.

Hi, Tom.

I know we are hitting -- I know we are hitting a lot on this topic past, so I appreciate your patience but you know this is a big topic. So, I guess, just further to the kind of role of Sammy and how you think about I guess outside resource and how important that is to your PSR initiative. I mean should we view him as essentially, he’s a consultant but he’s essentially full time at KSU for the next year, the next two years, maybe just a thought on that? And then you know is it helpful to bring in additional people to kind of help with the -- not necessarily at high level but just to help with culture change that typically associated with some of the PSR initiatives. So, I guess, that just some more on PSR?

I think, Sammy, will be with us you know unless something unexpected happens for two years. The incentive structure that we have put together has a two-year measurement period on it. He will not be full time. I know he’s got some other commitments and other activities unrelated to us, but I don’t worry that we will not have his full attention. I am pretty sure that even when he’s not here, he is going to be engaged and communicating with the team and thinking about things that we -- that we are doing here. And as far as your second question, we will just have to see if we get the kind of engagement and momentum the we are all hoping we get and sort of transfer of some of the knowledge that Sammy has from his 20 plus years of experience implementing this then we may not need additional outside resources, but we will just have to gauge that as we move along and see how the team engages.

That -- yeah. That’s great. I guess just for the quick follow on if I can. On a multi-year OR target, can you give a quick thought on volume sensitivity to that, could you give us a volume view for 2019 and an OR target is 2021, I mean, is it -- is that a good OR target even if you hit kind of flatter volumes in out years or do you kind of need the ‘19 framework to continue in 2021 to hit the OR target and thanks for the time?

Well, Tom, this is Mike. Obviously, volume is an important part of the equation in improving OR and as we look back on 2018, we didn’t generate that volume growth. Some of it because of the shutdown of the coal facility, but other areas we just didn’t deliver. And so we do have an assumption in that three-year period that we are going to see volume increase consistent with what we have always suggested we were able to do and we do have some outsized growth areas that we think will allow us to generate that kind of volume growth. What’s unknown right now is just how much cost we are able to take out over the next few years and that will become a little bit more important -- visible to us as we proceed down this path, and now I would like to thank that we get into mid-year and have some better targets around cost reductions. So you may have a couple offsetting items there but the plan definitely looks to volume growth to help deliver some of that margin improvement.

Okay. Thanks for the time.

Okay.

Our next question is from the line of Matt Reustle with Goldman Sachs. Please proceed with your questions.

Thanks for taking a question. Just a follow up on the OR target that you did provide, it’s a bit lighter than what some of your peers have laid out and what some of the peers have achieved, is that just being conservative, because you are at the early stages of analysis or is there something about the network or your focus on growth that keep you from guiding to subsidiary?

I think it’s a bit conservative and reflects that we are pretty early on, and perhaps, more aggressive improvements that might come out of the efforts here in the next few months. It’s pretty much in line, maybe a little bit higher, but pretty much in line with our peers.

Okay. Yeah. That makes sense. And you already mentioned the U&P [ph] implementing PSR, interchange partners and planning PSR. Are you seeing any impact today, any issues with service today as they go through that process?

Yeah. This is Jeff. Now we are not really seeing any difference as of yet in service. I think again the opportunity will continue to have to work primarily with Union Pacific, which now joined kind of goals on streamlining train starts, train length initiatives. Again, I see this as a positive as opposed to a negative necessarily on any changes that other interconnecting carries may embark on them.

Okay. Great. Thanks for taking my questions.

Our next question is from the line of Allison Landry with Credit Suisse. Please proceed with your question.

Hi. This is Sam Allen on for Allison Landry. Thanks for taking my question. You have spoken about working with customers to create more efficient on loading in order to improve car cycle times and fluidity. How does that fit in with the PSR implementation?

This is Mike. I will take that one. If you think about the process, you have to pick it up, you have to transport it, you have to deliver it loading and unloading is critically important. If our assets sit too long at a customer origin or destination, those assets aren’t turning, if we have to wait for customers to load or unload that’s going to cause a disruption in the network. We believe that our customers will participate with us and many of them have already started to participate with us in terms of improving their loading and unloading time. It’s going to work to everybody’s benefit and improve service if everybody does their share of the work and does it on time.

It’s just also going to result in reducing congestion at some of the yards improving the way we can operate for other customers and improving the overall velocity performance of our equipment, our locomotives, our crews, everything, so it ties in very nicely

Okay. And then given that volumes came in later than expected in 2018, what gives you confidence in the 3% to 4% range

As I said earlier, just we know we could have done better than what we did in 2018, because of service and then we have talked about some of the unexpected or the impact of customer specific events like the coal customer or so. If you set that aside you believe that our service recovery is well on its way to being fixed kind of back to normal, and then further improvement. And then feedback that we have gotten from customers and really analyzing these opportunities gives us a high degree of conviction that if we can sustain a higher level of service and operating excellence, and the customers continue to invest in the facilities that they are building. We think we have got pretty good visibility into what the volume growth outlook will be.

Thank you. Our next question is from the line of Brian Ossenbeck, J.P. Morgan. Please proceed with your question.

Good morning, Brian.

Hey. Good morning. Thanks for taking my questions. So I just want to focus on volume for a second and specifically the Mexico energy reform opportunity. Can you give us a sense of what’s in your expectations relative to 2018? And more specifically you have seen a lot of headlines with AMLO and the administration that in fuel set of being shortages present an opportunity to actually import more across border or are you sort of constrained by the infrastructure for the time being?

Yes and yes, it is an opportunity, I will tell you and José is still on the phone here. But we have had a very high level of engagement with very senior cabinet level officials in Mexico talking about developing a -- more of a longer term sustainable rail strategy for moving refined products. So we don’t know exactly how that’s going to play out. But if there was infrastructure available for loading, storage, transloading, there was more infrastructure available in Mexico, we would be moving more product than we are today. So there is a opportunity and I saw just yesterday that there have been some customs changes to facilitate and streamline the movement of refined products from the U.S. into Mexico. So we feel very good about that opportunity, don’t have a good answer to your question about what’s the upside, how much more could be moved, because we are literally in the middle of those conversations with -- particularly with the government as we speak. Mike, if you have anything to add to that?

I think, there’s certainly some uncertainty in that space. However, we are very much engaged. I mean [inaudible] made it clear that Pemex intends to compete in the marketplace and our perspective is that KC will serve Mexico’s needs whether that comes domestically or across the border.

Okay. And then one more on the guidance of 3% to 4%, we have talked about Sasol a lot and you haven’t really given anything specific, but at least it seems like it continues as there as they might be seeing some production delays, they have postponed one of their own updates. So can you give us any sort of context as to how you are thinking about that from a projection perspective in that 3% to 4% for next year? Thank you.

Well, I think, we are expecting strong growth in the plastics business unit. With respect to Sasol, yeah we are aware that the plant is mechanically completed but they are working through bringing their plants online and we are not expecting to receive any material shipments from them until late in the year and we don’t expect that they will ramp up to full production, probably, until 2020. But we really can’t speak for Sasol, those are questions that are best answered by them, but that is what we are considering in our plan.

Okay. Thanks a lot.

Our next question is from the line of Ken Hoexter with Merrill Lynch. Please proceed with your questions.

Hey. Good morning. I know you have run on for a bit here, but I just want to say, Sammy, great hire or addition to the team, even if as a consultant. But maybe Pat, just a little bit more on that. When you say certain principles, can you describe what is relevant to your network and maybe what’s not? I just want to understand when you say you are going to adapt certain parts of it, what should we expect?

I think some of the examples that Jeff gave earlier. I will ask Jeff to provide some more color commentary on that.

Yeah. Certainly for me -- we have got to get a more consistent service product. I think we performed well, we saw last year, we didn’t perform, as well as we had historically or liked to. So consistency is probably one of one of our keys and in doing so again, train start rationalization, simplifying networks, total train starts, again, working with customers on right-sizing equipment, taking some excess equipment off the system, all will allow us to kind of flow better and for me consistency is really what we are -- what we need to achieve here most. Other areas we are touching on a lot, I just mentioned a few. Fueling, it’s interesting to see we have processes for fueling and I will give one more detailed example of locomotive shutdown process. We have technology that shuts down locomotives automatically, we have manual processes and just the experience or viewpoints from Sammy or from Hunter via PSR on things like that is that we do save some money on how we shut down locomotives. However, we probably increase our locomotive failures upon startup. So making decisions based on more experience and kind of what Hunter’s methodology has been throughout his career may shift us one way or the other on technologies or pieces such as that fueling. I mentioned locomotive fleet, how we are going to look at that, how we are going to right-size and have opportunities to look at locomotives and kind of rightsizing locomotive fleets, equipment is another big one. So I think really what you are hearing from other PSR implementations, again, I look across these segments and I don’t see any of those that aren’t really kind of applicable to our network in some form or fashion. Again, I think, we do talk about the interchange as part of that, then we are different in terms of interchange, but again the shared goals that we have to create more efficient interchange wherever it may be to use them certainly at the border, working with interchange partners better to improve fluidity there as it is in everybody’s mutual interest. I think one of the things I am excited about is to see from a Union Pacific perspective with PSR kind of streamlining efficiencies to use them, we know that that’s -- for an industry, that’s important -- that’s an segment and an important geographical region for the rail industry that is we can streamline and simplify operations collectively through areas like that, I think, we all will benefit.

Ken, this is Mike. Maybe just one other quick thought and Jeff kind of alluded to that earlier and Pat may have made a comment. But there’s been a lot written or said about do these principles apply to KCS because of our smaller network, and obviously, we are interchanging a lot of traffic with UP, but Mexico looks and feels a lot more like the other rails with originating and terminations on our own network there. So I think that gives us some additional confidence that we can gain a lot of leverage there.

I appreciate that. I don’t think anybody’s ever questioned whether it would work I think and to prove that it is his first stop at ICC. But I guess I want to understand, Pat, do you view this I mean with Sammy as a part time consultant I was a bit surprised by that. I mean I think it would be a great addition to the team, but as Tom mentioned before, you typically see PSR is kind of a complete overhaul culture change. So do you see this more as a mechanical adoption, and kind of as Jeff you were mentioning, kind of doing piece parts versus a complete overhaul of culture change, slashing employees, cutting CapEx, changing how customers behave? I just want to understand is this incremental or is this kind of usually a PSR is kind of a shock to the systems completely changed fundamentally how you operate?

I think it’s a bit more incremental in our case. And I just remind people that we are not coming -- going back to the hunter’s experiences. We are not coming from kind of the distance to the pack in terms of operating ratio and performance. And I think if I will even remind everyone thinking the one of the conference calls that the Hunter had when he was at Canadian Pacific talking about his desire to acquire, I think this might have been Norfolk Southern. But the question was raised what about if it doesn’t work out, would you pivot to Kansas City and one of the comments he made was well they run a pretty good railroad there. So I don’t know that the magnitude of the change that we see is such that kind of as you refer to a culture shock is necessary or appropriate. We have done a lot of work here internally with our employee base in U.S. and Mexico over the last couple of years about culture, principles, values, accountabilities, I think, all of this fits in with the work that we have done there. So I think it’s much more of an incremental. We will do this in a manner that is consistent with the culture and values that we have been talking about with our employees for really the last couple of years and so I think it is going to be a bit more incremental, which doesn’t mean that it can’t be pretty powerful in terms of the magnitude of the impact. And at the core, as Jeff mentioned, at the core of all of this is focused on service, serving our customers, yes, we will probably have some change management to do with customers as certain elements of this rolled out, but getting our service to a level that is consistent, sustainable and allows us to realize the growth opportunities that we know are out there of course.

I appreciate all of that. Thank you. Just a quick one if I can sneak one in the autos you mentioned a positive outlook, but it’s started off pretty negative. Is that significant closings or overhauls to start or anything just a quick one on the auto thing?

Sure. This is Mike. The number of the automotive manufacturers in Mexico are going through plant shutdowns throughout the holiday. We got off to a slow start two of those plants ended up taking a week longer to start up and we had expected and planned for that’s why we started a little bit soft. We are seeing a recovery now as those plants come back online.

Great. Thanks for the time guys. Appreciate it.

Thank you.

The next question is from the line of Jason Seidl with Cowen and Company. Please proceed with your question.

Thank you, Operator. Good morning, gentlemen.

Good morning.

Looking at ‘19 in terms of your OR outlook, how much of your conservatism and it takes the fact that two of your major interchange partners are implementing PSR, and that reminds you that in some blowback on operations because of that?

Well, we haven’t seen that. So, I don’t know...

Knocking on the wood when you heard that.

Sorry.

I said that was me knocking on the wood when you said that.

Yeah. Yeah.

Yeah. This is Jeff again. I mentioned earlier, we haven’t seen any material change either way with major interchange partners. And I think again that the relationships that that we have with you UP remain strong. I think Sammy and his experience with Mr. Venna [ph] also are going to help support that. And again as we have talked it’s in our mutual best interest to run a more fluid network and that depends on both kind of both sides or both partners whatever interchange partner we are working with really looking at that and working together better on how we can streamline, streamline flows. If we are able to reduce train starts, great longer trains do just in complex that’s going to create better fluidity and help the overall network.

Okay. All right. That’s understandable. I want to switch to my next follow-up questions to Lázaro. You talked about your activities were spread down and I know that came around sort of get back to some of the shippers, because the exchange rate was making a very unfavorable versus sort of the local shippers down there. Can you talk about those givebacks and the impacts on the reported pricing numbers and how that maybe would look Exa?

Sure. I am happy to talk about that a bit. So we do have a rebate program in place targeted to grow traffic out of Lázaro into Mexico City. The concept’s relatively simple. If the shippers hit their growth rates, then the rebate is applied accordingly. That rebate basically neutralizes the effect of some of the costing issues that we have that make us less competitive. These rebates are basically in operation, while the exchange rates are greater than 17 pesos per U.S. dollar. So they do fluctuate depending on the value of the peso. And if they don’t hit their growth rates, then no rebate is paid out. So we believe that it’s making us competitive in the marketplace.

And so what sort of an impact -- what sort of an impact did that have on reported pricing?

It was very immaterial.

Okay. That clears it up. Gentlemen, I appreciate the time as always.

Thank you.

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

Hey. Thanks. Good morning, guys.

Good morning, Scott.

So are you guys implementing any of the asset story all demurrage changes in intermodal lane closures like we have seen from the S&P this year?

Yes. We are evaluating the rates that we provide or that we charge for services that we provide. So the answer is, yes.

We are evaluating at this stage. As far as intermodal enclosures, no, we haven’t considered any of those.

Scott, I think as we look at again our largest or kick off really opportunity for PSR’s, as I mentioned intermodal manifest. It’s more of probably consolidation of trains and if we look at train length and our ability to more merge or combine those types of traffic to reduce train starts as opposed to rationalizing an entire intermodal lanes as an example.

And remember, Scott, our intermodal business is kind of in discrete categories. U.S. on the Meridian Speedway where we are a bridge carrier, we have our cross-border network and then Lazarro. So they are probably are a huge opportunity to go walk away from segments of that business.

Right. It makes sense. Okay. And then, I want to just make sure I am understanding sort of the message on this PSR path. So as we have seen the other models play out, right, meaningful sort of 20% plus reductions or improvements in labor productivity meaningfully lower CapEx and locos in step functions in OR, CSX, CP 1,000 basis points in two years, right. I get the message, right, it’s early and we are not really sure exactly about. Are these sorts of things in your mind in the realm of possibility or is it that, hey, our starting point much better, we are doing little bit differently and don’t get too carried away. I just want to make sure I am really understanding the message?

I would say you -- your final comment there. We are starting from a different perspective than some of the other examples out there. So we don’t feel that the magnitude of that sort of initial pop is going to be the same in our case as it was at couple of the other railroads.

And I know you have shied from this maybe a little bit, but are you willing to say where the U.S. is because I did, I thought like historically that was closer to the 70 than low 60. So I would thought there would be a big opportunity there?

Scott, this is Mike. We are -- we are not going to go there. We have continued to make improvements in the U.S. and we will continue to make improve -- improvements going forward, but we are going to stick to our consolidated business, our bread and butters, the cross-border and it takes both sides of the U.S. and Mexico to generate the kind of profitability that we are.

Okay. It makes sense. Thanks so much, guys.

That is truly how we manage the network.

Thank you. Our final question this morning is from the line of Fadi Chamoun with BMO. Please proceed with your question.

Yes. Good morning. Thanks for squeezing me in here. Just a couple of clarification, is there anything in the labor agreements in Mexico that might make the application of PSR like we have seen it elsewhere more difficult? And the second question is just really clarification on your slide 15 I think over that volume outlook slide. You say there is a risk to the crude outlook, the heavy crude outlook in 2019 due to Canadian crude production cuts. I was under the impression that these agreements were take or pay with volume commitment. Is that not the case?

Yes.

Yeah. But it’s not -- the agreements provide compensation, if there -- if the volume commitments or targets are not met, but they don’t have to ship the product, so you could have an impact on our volumes but there is a mechanism to recoup particularly the capital investment that we have made to support that business.

That means said another way that per car charge that we will get for not moving the volume is less than the margin we would have received on the carload that would have moved full.

I will take the initial question on the labor. Now that the outlook in Mexico really doesn’t prevent us from gaining efficiencies through labor productivity, we will probably go at it a little bit differently. We still have -- as we have talked about three and four-person crews in the cab in some areas, so you might see target or you might see one-time restructuring activities as we negotiate with labor to try to maybe gain efficiencies in those areas, as opposed to the other aforementioned activities on train start rationalizations. But there’s really nothing structurally different that would prevent us from right-sizing labor forces.

Okay. Thank you.

Thank you. At this time I will turn the floor to Mr. Ottensmeyer for closing comments.

Okay. Thank you all very much for your time and attention. We will be active here in the next few weeks on the conference circuit and plan to provide updates, and probably, more details as we get further into this. So stay tuned to that. And I think the only thing I can think of to say is we close out is go chief. We will see you all in about 90 days. Thank you.

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