Good morning and welcome to the Kansas City Southern Second Quarter 2019 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. After today's presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note this event 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, 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.

Okay. Thank you and good morning, everyone. Welcome to our second quarter earnings call. Just to make a comment on Slide 4, which is the list of the line up for today’s presentation. I’m not going to read through this. I think it is very well known to the audience here. So I will move on to Slide 5 with a quick overview of the quarter and a few headliners. As you saw from the press release, revenues increased 5% to a record level for any quarter of $714 million. Second quarter operating ratio, little bit of explaining necessary here. We reported a 70.9% operating ratio, which includes the impact of impairment charge, additional impairment charge we took in the second quarter. Adjusting for that impairment charge, we got to 63.7%, which is a 30 basis point improvement from last year. That included negative impact of 130 basis points of pure accounting, I will say, related to the loss of the IEPS tax credit and the increase of fuel surcharge revenue. Mike Upchurch will go through this in much greater detail later and explain the 130 basis points and probably more importantly explain what this looks like going forward. This is really pure accounting as we're just inflating the revenue side as well as the cost side of our income statement, which has a negative effect on the operating ratio, but has very little effect on operating income or other things that matter as you go down the income statement. So I think it is correct to look at the 30 basis point improvement from the adjusted level, excluding the impairment charge as well as the 130 basis point excise tax impact that we absorbed or overcame in the quarter due to the pure accounting consequences of both higher fuel…

All right. Thank you, Pat. Good morning. Starting with the review of key operating metrics for the quarter on Slide 8. Dwell of 21.2 hours, improved 11% year-over-year, while gross velocity of 12.5 mile per hour improved 9% year-over-year. We continue to see strong year-over-year improvement in our key metrics, particularly in Mexico were dwell across the majority of our major terminals has shown significant improvement. Flooding had some impact velocity interchange in the North end of the U.S network as we encourage several days of outages across some segments. The greatest impact was to interchange of bulk commodities in Kansas City. Regarding asset utilization, I would like to highlight that the number of operational cars online has decreased 17% versus peak 2018 levels. Our focus has been to reduce high cost foreign equipment by improving cycle times and working with customers to right size fleets. Border performance for the quarter remain solid and supported a 10% year-over-year growth in cross-border volumes, led by significant growth in Mexico Energy Reform shipments. A milestone was reached in our border operations in July as international crews have now been in place for one year. This initiative continues to support cross-border volume and we're seeing a 20% reduction in time spent crossing the bridge for those trains utilizing international crews. Expanding upon PSR metrics on Slide 9, we continue to see positive trends in all metrics. Through the first half of the year, gross velocity has improved 10% versus prior-year and we're now tracking this metric to exit the year at 14 miles per hour. Reductions in line of road equipment failures, improved execution of TSP and modifications to our service design and reduced train starts have all helped to a system fluidity. Train length improved by 2% as our TSP and train starts consolidation work continues. In the second half of the year, we will undergo additional service redesign, which Sameh will discuss in more detail. Fuel efficiency has improved by 3% for the year. Multiple initiatives, including velocity improvements, locomotive utilization, train start reductions and fuel technology are all contributing to this improvement. In the second half of the year, we will install fuel technology on an additional 100 road locomotives, which will bring us to roughly 50% of our road fleets equipped. Also, of note, we’ve received all 50 of the new locomotives planned for 2019 and do not currently plan any locomotive purchases for 2020. As Pat indicated, we feel very good about the progress and pace of our PSR initiatives and as you will see in Mike's financial review, we are more than doubling the expected PSR cost benefits for the full-year 2019. I will now turn the presentation over to Sameh to provide more detail on our overall PSR efforts.

Good morning. As Jeff mentioned, we have been making significant improvements in network velocity in about 10% that are year-over-year and well about 8% better. We are seeing the best consolidated gross velocity this time of year across the network than we have seen in any of the last five years. We also see further improvements ahead as on many days we achieve 15, 16 miles per hour in U.S and 13, 14 miles per hour in Mexico. These are much higher numbers than the average of 11 miles per hour reported last year. These improvements were achieved by very hard work every day by the whole operation team with intense focus on every low velocity train and peeling the onion on causes. Example, a train that arrives in Nuevo Laredo and departs 24 hours later as it waited for a window to cross the border bridge. That has also been an intense effort to scrutinize work in yards. As an example, Vanegas having nine trains doing work versus a planned six. As we drill down, we find that cars were added to a train in Sanchez and now needed to be switched out in Vanegas which is not our best yard for switching. Velocity which is not our best yard for switching. Velocity and dwell gains translated into the removal of 12% of our locomotives and 7% of our cars and great improvement in fuel efficiency. In addition, four waves of train consolidation resulted in a 10% reduction in planned line of road crew starts in Mexico. We continue to focus our efforts into converting our operational gains to the bottom line and as Pat mentioned, Mike Upchurch is going to go more into the financial details of this. Now moving forward, the same way as a field visit…

Thank you, Sameh, and good morning everyone. I will start my comments on Page 13. Overall, second quarter revenue was up 5% on flat volumes. As you can see our Q2 performance was mixed across business units. We continue to see very strong performance in our cross-border traffic, led by the Mexico Energy Reform business and this drove growth in our cross-border revenue and volumes of 13% and 10%, respectively. We are mindful of the economic environmental trade situation and we continue to carefully monitor the current state of affairs. And as you’ve heard from Pat, 80% of our portfolio have a favorable or neutral outlook. During the quarter, our revenue per unit grew by about 4%, driven by a shift in business mix from the lower revenue per unit intermodal volumes to the higher revenue per unit chemical and petroleum business. Increased fuel revenues also affected our revenue per unit. During the quarter, we achieved pricing renewals consistent with the prior year and we view the current pricing environment is stable. As expected, the Chemical and Petroleum segment delivered strong quarterly year-over-year results with our Mexico Energy Reform business providing revenue growth of 136% and volume growth of 125%. Our Ag/Min units showed a slight year-over-year volume decrease to a large part to an unexpected customer outage and timing of volumes contributing to tougher year-over-year comps. However, we continue to see favorable transportation cycle times, resulting from the benefits of operational improvements at cross-border traffic. We expect to see this trend continue into the second half. Energy volumes were down due to decreases in frac sand and Canadian crude or partially offset year-over-year growth in utility coal traffic. And this was despite the flooding impact that occurred in the second quarter. Year-over-year revenue in our industrial consumer business unit…

Good morning, everyone. I will start my comments on Slide 16. Second quarter revenues were up 5%, primarily due to a 4% increase in revenue per unit. Reported operating expenses increased $69 million, primarily due to a restructuring charge of $51 million consisting largely of an impairment of locomotives and freight cars no longer required in our business. Adjusted operating expenses increased 4% leading to a 63.7 adjusted operating ratio for the quarter. It is important to note that the Mexican government's decision to terminate the fuel excise tax credit for the rail industry beginning April 30, 2019 had a negative impact on our adjusted operating ratio of approximately 130 basis points. I will review more details on the impact to our financial statements on the next slide. Setting aside the negative impacts of the loss for the fuel excise tax credit, our operating performance was far better than our reported or adjusted results. Our adjusted effective tax rate for the second quarter was 29.2% in line with the 29% to 30% guidance we provided. For 2019, we do expect our full-year adjusted ETR to be in the range of 27% to 28% due to the Mexican fuel excise tax been included in income taxes. Since IEPS is now been eliminated for the remainder of 2019, we will no longer adjust the fuel excise tax credit in the operating expenses. In June, the Treasury Department proposed additional guidance concerning guilty tax and we now expect our effective tax rate to be 28% to 29% in 2020 and beyond. And from a cash tax rate perspective, we're forecasting 2019 to be 21%, 2020 to be 23% and 2021 to be 25%. And while the Treasury Department has largely solved concerns that caused unintended consequences to KCS, we will still end up…

Okay. Thanks, Mike. I will just touch on a couple of things and restate a few things for emphasis before we open it up for Q&A. We feel really good about the progress we're making. Obviously, we'd like to see a more robust volume environment that as Mike explained, 60% to 80% of our portfolio we still see as favorable. And with the exception of intermodal, we still see good growth opportunities in the quarters ahead and the -- what we -- what I refer to as the oversized growth areas that we talk about a lot. Automotive, refined products moving into Mexico and plastics coming out of the Gulf Coast. So those businesses still look very solid. They’re producing both volume and revenue growth and in spite of overall flat volumes we're still seeing good revenue growth and sticking with our volume revenue guidance from earlier this year. Mike also mentioned our cross-border product continues to grow double digits in both volume and revenue and we feel there's lots of opportunity for that to continue. We are producing and delivering core operational improvements, which are driving improved service levels, better asset utilization and increased profitability and cash flow. We are handling the same volume levels overall that we have of last year with 12% fewer locomotives, 7% fewer railcars and 10% fewer crew starts. And we think there's more to come in the months and quarters ahead as Sameh and Jeff both mentioned, we're just beginning to completely restructure and whiteboard our transportation service plan, which we are confident will lead to further asset savings and cost savings and service improvements in the months and quarters ahead. We are taking our PSR related operational savings up by more than 2.5x in terms of impact to 2019 and beyond. And we will continue to update investors as we get further into this and particularly in the third and fourth quarter when we see the results and the benefits of our TSP whiteboarding exercise. And we still feel very good generally about our overall portfolio and I will just restate 60% to 80% neutral or favorable, a few outliers that are having a bigger impact on volumes than they are on revenues, reducing our CapEx accordingly, improving free cash flow. I think our free cash flow conversion rate is increasing as well. So, all in all, in spite of some troubling signals in the economy and still some unresolved trade issues, we feel really good about the progress we are making and still feel good about the outlook. So with that, I will open the call for questions.

[Operator Instructions] The first question comes from Chris Wetherbee of Citi. Please go ahead.

Yes, hi. Thanks. Good morning, guys.

Good morning.

Maybe, Mike, can you start on Slide 17. I just want to make sure I understand sort of what the moving parts with the fuel tax credit this week and kind of get that out of the way. So in the second quarter I think you guys have been expecting an 80 basis point headwind that ended up coming in a bit bigger than that. Sort of the way that we’re thinking about this now, the way that we should be looking at it going forward. So maybe if you could sort of parse what happened, the difference in the quarter between the 80 and 130? And then as we go forward in the context of the rest of the year and obviously the 2021 guidance, we should be assuming that include this 80 basis point ongoing headwind?

Yes, exactly, Chris. The guidance assumes we are going to absorb this negative 80 basis point impact and we are going to be on the low end of the range. So you should view that as improvement driven by both of those items. And the 80 basis points is what we believe will be the impact going forward in each quarter. The reason it was a little higher in the first quarter or second quarter was really for two reasons. One, we have the timing issue of losing the credit on April 30 and not getting it on customer bills until mid May. And then, secondly, since we are not going to adjust this anymore, the -- in quarter benefit related to the IEPS credit that we did get is sitting down in income taxes. But that's exactly right. I think you got that right.

Okay.

Chris, there is a -- the 80 basis points over time there is a part of our as Mike mentioned, a part of our customer base that pays and -- an all-in rate so between contract renewals we don't have specific fuel surcharge. So it'll take a while for us to catch up, if you will, and perhaps adjust those contracts to reflect that all-in rate versus rate plus fuel. So that 80 basis points could come down as those contracts are renewed. And it's also important, I think we’ve mentioned this in other venues, we are challenging this decision. The loss of the IEPS tax credit applies to railroads only. So our truck competitors and other modes of competition did not have the same regulation and rule come down in their case. So we think it's discriminatory for us and we're challenging it and we certainly elevated this in our dialogue with government officials in Mexico, but certainly don't want to make any prediction about the outcome of that. But we're trying to defend ourselves here from a market competitiveness standpoint as well as our customers interests, and that will continue to do that.

Okay. And ultimately there were very little impact in operating income. It looks like less than a $1 million a quarter going forward.

That’s the point. Because you’re increasing your revenue items and an expense item by roughly the same amount, it has a bigger impact on operating ratio. But when you really go down the income statement and think about the dollars and paces involved it's minimal.

Okay. And if I could ask a follow-up just on the capital structure. Mike you had some comments there. It couldn’t help, but notice that CapEx guidance come down a little bit. Obviously, profitability with the OR improving, is going up. The leverage is sort of trickling towards the lower end of maybe where the peers are moving, so how should we think about sort of the capital structure as we go forward? It seems like a high-class problem to have that free cash flow generation is likely to step up as we move forward and we think about things like accelerated stock repurchases or anything else that might be thinking about from a capital structure perspective.

Yes. Well, you got that exactly right. We’ve a nice problem and we will continue to have nice problem. More and more cash flow generation as a result of the items that you indicated, obviously increasing cash from ops and lower CapEx, we are going to create a better dynamic for us going forward. Obviously, this is a decision we will have to reach with our Board and I did indicate we would be meeting with the Board specifically on our capital allocation policy before the end of the year. So stay tuned. We don’t have any news today, but we will soon.

Okay, perfect. Thanks very much for the time. I appreciate it.

Okay. Thank you, Chris.

The next question comes from Amit Mehrotra of Deutsche Bank. Please go ahead.

Thanks, operator. Good morning, everybody.

Good morning.

Mike, I’m not going to ask you about the excise tax credits, so you’re welcome.

Thanks, Amit.

But I did want to ask about the revenue growth guidance being left intact despite the lower volume outlook. Obviously, it implies a uptick in yields in the back half compared to the first half, which typically isn't the case if you look at prior years. So if you could just help us think about the underlying assumptions there, discuss a little bit more comfortable with the assumed deceleration?

Yes, sure. We had indicated in or Pat has indicated kind of volume being flat to slightly down. If you look at our results through the first half of the year, we were down roughly a point. A lot of that related to first quarter, teacher strikes, but obviously we are not -- we certainly hope won't happen in the back half of the year, so flat to slightly down. And then I think you need to think about mix. Obviously, the intermodal business is a little bit challenging in today's environment. So with a lower revenue per unit you can read into that. We’ve got a little bit softer outlook on intermodal in the back half of the year, but offset by refined product which has a very good length of haul and what we think will be good grain volumes going forward.

Right. So it's not -- it's really the mix of volume as oppose to any assumed acceleration in pricing? Is that the way to think about it?

Correct.

Okay. And then let me just -- for my follow-up, I just wanted to ask about the different buckets of the cost structure. Are we going to see a more sizable reduction in the workforce. It's by far the biggest piece of the cost structure. I would just imagine the structural improvements you are making could translate to great opportunity for labor productivity whether that means proactive reductions in workforce or maybe a limited need to replace those who leave to attrition on your attritions a little bit, may be high single digits every year. So can you just talk about that and when, if at all more step function increases labor productivity are going to be part of this plan going forward?

I'll provide some initial comments here and then maybe ask Sameh and Jeff to provide little more detail, but -- I will state the obvious the best of all possible outcomes is that we improved labor productivity and then we see growth opportunities come into create demand for those services, those assets, those people. But we don't necessarily have complete control over the rate of growth that we’re seeing. Yes, I think obviously the things we're doing in terms of fewer train starts, redesigning the network, I said this before in previous quarters, we’re getting out of our own way. We are removing congestion, we're running a more fluid and efficient railroad and that's going to result in fewer. At the same volume levels, that's going to result in the need for fewer locomotives, railcars and crews and then have a further ripple effect in terms of mechanical assets engineering possibly as well. So in a flat volume environment the things we're doing should result in further productivity improvements and possibly lower headcount requirements going forward. We also have and we’ve talked about this for a long time. We have work rules in Mexico that are not lined up with the way things work in the U.S and we think there are some opportunities for gains there as well. The mantra of our PSR efforts as some of you know is service begets growth. So we're hoping that by doing all of these things and improving the way we run our railroad producing a more consistent reliable and resilient network that we are able to take better advantage of some of the growth opportunities that we see and we can put all those assets to use. But if that growth doesn't occur quickly, then we will see further headcount and labor productivity savings. Now, Jeff or Sameh, have anything to add to that.

I will just add and then I will let Jeff expand on it. Jeff is spending a lot more time on this on the labor relation front. But in general, by reducing train delays, which we have been putting a lot of emphasis on and that's how we have been achieving a lot of -- the velocity improvement, it clearly have reduced or improves as an example. By reducing train starts, well again, you have a need for less crews because you have fewer trains. By reducing switching in yards and enforcing compliance at least with existing plan to begin with and hopefully with the new plan, the new service plan, train design and yard design, we should reduce switching even more. Well, by definition, while going to need also less crews in yards. So you look at all these and then add to it the mechanical side where we have taken the worst locomotive result of the fleet that had 8 failures per year and 10 failures per year when decent good locomotives have about 2 failures per year. There is a significant reduction in the workload in shops. So you add all that together, you achieve a lot of staff reduction. Now on the mechanical side, we have gone and done a lot of these staff reductions. Some of that has been offset by some of the in-sourcing activities because labor in shops makes a lot more sense to be a reporting to the company, not reporting to a vendor and as a result we have had significant savings in money on that. So, yes, the comp can go up, but the money I think one shop alone was $4 million less per year in expense. We also went ahead and close one shop in Monterey. So in-source San Luis Potosi, but we close Monterey. So, in the mechanical side we have taken the actions. On the transportation side because of the work rules that Pat mentioned we cannot just arbitrarily go and take action. We still have four men crews in many places, in many situations and we have to work on that was our colleagues from the union and I think Jeff you can expand on that.

Yes, I will just add a couple more talking points. The tale of two countries a bit. In the U.S., we’ve actually added some crews as part of our efforts. And Sameh talked about Houston, that's -- again that’s just -- it is more fluid today, but it remains a difficult spot. It's our highest re-crew area of our network. And so, we’ve said it's better to have a little excess resource there and maintain and improve the fluidity versus trying to manage too tight. Cross-border, we’ve talked about we’ve added several crews in the Laredo and with international crews. On the flipside, in Mexico we do have opportunities. We’ve talked in the past about still having three and four person train crews. Those are collective agreements. We're actively working on. However, that's just progressing little slower than we would like. Keep in mind though that the crews while we don't have furlough ability similar to U.S., if the crews are running trains as we talked about crew starts, they’re collecting just minor benefit from a dollar perspective. I know Mike mentioned, we've had about a $1 million to kind of efficiencies with what the train start reduction. So not 100% focused on the headcount for Mexico because of those cost factors, but still something we are going to continue to work on through the rest of the year. We believe there's opportunity and hopefully we get some work completed with the Mexico Union. If not, that will just proceed a little slower as you mentioned to attrition.

Okay. I appreciate the comprehensive answer. Thanks everybody.

The next question comes from Justin Long of Stephens. Please go ahead.

Thanks and good morning.

Good morning.

So just to clarify on the 2021 OR target, does that just include the $55 million of PSR OpEx savings since you spoke about or some number that’s higher than that based on other initiatives you have in the pipeline? And then, Mike, also on the PSR savings, could you talk about what you recognized in first and second quarter as we think about what's incremental in the back half to get you to that $40 million number?

Well, let me start with, I guess, your second question on PSR savings. You know, the amounts that we disclosed here on page 18 are recorded throughout the course of the year. So we now expect $40 million to be the savings as a result of PSR actions, but that would go up each quarter as you’re getting full benefit for those initial reductions that we identified. So I don't know if that entirely answered your question, the $40 million is kind of a buildup throughout the rest of the year and the exit rate will be higher, which will lead us to $65 million of annual expense savings in 2020. With respect to your other question, we clearly have a view today of having better expense savings as a result of our first six months of PSR activities, that's why we moved to the lower end of the guidance that we had set for 2021. And remember, not only did we move to the lower end of the guidance, but we're also going to absorb the 80 basis point negative impacts from the loss of the fuel tax credit. So, obviously, where we’re at in PSR savings today did factor into us improving our outlook out into 2021.

Just to add to that there are lots of moving pieces to operating ratio, including revenue and volume growth, incremental margins, pricing etcetera. And then there are other things that we’ve talked about just recently here and in the presentation about the PSP whiteboarding, we fully expect that that's going to produce another -- possible another wave of improvement here and then some of the labor issues that Jeff and Sameh talked about. We -- I will say, we don’t have all of that because we’re at the beginning stages of some of that into our guidance. So, we will update guidance as we get better clarity and better information on some of these initiatives, but I don't -- I will state it for you, you didn’t see it this way, Justin, so bear with me here a little bit. We certainly haven't declared victory on this at this point. We still feel like we're fairly early on and have room to improve further.

Okay, That’s helpful. And then secondly I wanted to ask about intermodal. Clearly, this is an area where we’ve seen a bit more pressure recently, but when do you think intermodal volumes can start to inflect positively and do you need the truckload market to improve in order for that to happen or can you see intermodal growth from company specific areas, even in a looser truckload capacity environment?

I think that we can certainly pursue growth opportunities and we are doing that. For example the cross-border intermodal traffic continues to grow despite overall pressure on the U.S domestic marketplace. I do think though with respect to the U.S domestic marketplace we’re going to need truck capacity to tighten up in order to improve that situation.

Okay. Thank you.

The next question comes from Allison Landry of Credit Suisse. Please go ahead.

Hi. This is Sam Yellen on for Allison Landry. Thanks for taking my question. As you just said, we’ve been seeing some softening in the U.S trucking market. I was wondering if you could talk about the Mexican truckload market a little. Have you been seeing some more softening in Mexico? And has that been a drag on Intermodal volumes as well? Thank you.

So actually we indicated that we saw improvements in our Lazaro intermodal business. It doesn't seem to be experiencing quite the same challenges that we're experiencing on the U.S domestic side of the marketplace. We have a little bit of a disadvantage because of the discriminatory pricing actions resulting from the fuel situation. So we will have to address that over time as we look at our contracts in our volume requirements.

I will just add to that and what Mike said earlier about the U.S domestic versus other segments of our market. In our appendix and background information to our presentation we do call out the cross-border in Lazaro intermodal volumes and revenue, so you can see we are seeing growth in those markets. And the area that we’re seeing the most weakness, which is a big part of our intermodal business, but certainly not all of it is the U.S domestic.

Thanks. And then also can you give us an update on your initiatives in the Houston area, specifically are you seeing incremental progress in this area and what you view as the biggest risk to reconfiguring traffic flows?

I can comment on that. This is Sameh. We have definitely made some operational adjustments to the Houston area. We changed from a method, if you like, of staging trains ahead of that area to try to avoid congestion and all that, a new method where we actually push our trains frankly through it. And also not worry too much about some of the -- it's difficult to explain on a call, but some of usage of sidings to park trains, which end up using the sidings for parking instead of train meets. The other thing we did is that we also stopped using detours, which were costing us a lot of money but also losing a bit of control on the transit time, time of a train. A combination of these things have really provided a lot more consistency in the transit time in that area. We see 12 miles, 13 miles per hour for that area when we use to see about 7 or 8 miles per hour. And it's happening now. Whether there is a peak of volume or reduction in volume, we're getting consistency and that's really important. And the other nice thing happening now after we did an exercise was our colleagues from UP for 2.5 days around-the-clock watching exactly what’s happening in that area is that not only we change our own method at KCS of avoiding that staging. I’m trying to predict and forecast on all that, but also the transit time itself in the area has improved because of much better dispatching and we see it in the amount of recruits that we endure. We have a lot of trains now that goes through the whole area without any recruits. So you can get through that 120 mile very important area between Beaumont and Kendleton in six hours which is very good. It used to be some times 15 and 18 hours. So I think we got this one pretty much under control and now we’re focusing as I said on my slide on the border and we are focusing on yards. These are the next two big areas where we believe we can make a breakthrough and improve our velocity and our dwell and all the other things.

Thank you.

The next question comes from Tom Wadewitz of UBS. Please go ahead.

Yes, good morning. I wanted to ask you, I guess, a bit about some of the yard work and whiteboarding. What’s the -- I guess, you didn’t talk about the Monterrey yard, I think that’s something in the past that that has been mentioned as a point of congestion. Maybe just where you add in terms of how the yards are functioning? Are they kind of cleaned up from the initial work which you’ve done? And primarily what you’re going to look for going forward as a reduction in train starts. How do we think about the, I guess, what you're aiming for in whiteboarding and what the result maybe on the Mexico operations?

Let me start and then I will -- Jeff, maybe you can continue here. I think there are two things when we think about yards. There is the inventory of the yard and I believe that's what you're referring to when you’re talking about Monterrey and that is an inventory that was a 1,000 cars higher back in December than it is today. And a lot of effort has been taken on that, trying to look at cars that that sit for a long time and trying to understand why they sit and working also with customers because a lot of these -- a lot of tracks in the yard are often used for what we call constructive placement which means the car is ready to go the customer, but the customer is not ready to take it. So we have been working a lot with our key customers in the Monterrey area in a very positive and partnership way and it has brought great fruit. That's one side when we talk about the yard. The other one is more of the operation and the arrival of trains and the departure of trains and the switching in the yard. And when I talk about San Luis Potosi and a week we spend there, walking in the yard and sitting in the tower and talking to people, okay? Talking to people tells you much more than anything you can read in annual report. They tell you exactly what the issues are and what the solutions are. When you look at the yard you find that, well, there was a train held up on the north side, there was a train held on the south side, because some trains came in close to each other not according to plan, but they came…

Yes, that -- I mean, that’s great. I guess for the follow-up, it sounds like there -- maybe two different -- a lot of opportunities where one of them is compliance and then one of them is the plan. What is it that -- what are you doing to really drive the cultural change and the compliance? And then just in terms of the way you implement after the whiteboarding, is this a design across all the terminals in Mexico? Do you kind of flip the switch in fourth quarter or do you go terminal by -- yard by yard and do things one yard at a time? Thanks.

Yes, this is Jeff. I will just expand on that. You got it right on. So I’m looking at this kind of two phase. First phase we’ve seen some good work is simply compliance. And compliance to current TSP, as Sameh mentioned in Monterrey yard, that been on the one big differences that we’ve had and just execution, increased focus, increased focus on a daily basis through Brian's team and the use of additional data and dashboards and tactical kind of business process folks really sitting in and dissecting the day-to-day operation of the yard, that's all added benefit as well as working with customers, rightsizing fleets. Sameh mentioned CT car, so I think that's really the bulk of the work that’s going on thus far is more that day-to-day tactical accountability and execution. As we look forward, again we’ve talked about a lot of the PSR opportunities with TSP is in Mexico because of our -- I will say overly complex intermodal manifest product that’s just how we operate down there. So looking at the yards and the handlings, reducing handlings, simplifying those products for improved fluidity, but also better product offering for our customers is really kind of the next second half of the year, I really think that's really what we're going to get to more long-term and structural changes to our TSP.

Thank you.

The next question comes from Brian Ossenbeck of J.P. Morgan. Please go ahead.

Hey, good morning. Thanks for taking the questions.

Okay.

Pat, I want to ask you more about the service. That was your mantra and you're expecting to see some growth here maybe in the second half of the year and in places like grain where service starts to improve. We can see that in your metrics, but whereas the ones that we still don’t see externally is some sort of up service besides being dwell. So can you tell us about how you’re viewing that internally which you’re talking to with the customers, do you have a plan to roll out a plan compliance or something along those lines?

Yes. We have a number of different metrics that we look at as far as customer service and customer satisfaction, I feel like from the moment that we actually started and announced our PSR initiative and started to work with customers, we saw almost from day one improvement in a lot of our key customer metrics. And the feedback we’re getting from customers and I will go back in a minute to talk about why kind of picking up on some of the couple, the previous questions about how we are going about this in a really cross functional way, even as we redesign the TSP, which we just talked about the engagement of the sales and marketing team, the communication with customers, all of those things, we’re trying to do this in a really thoughtful and cross functional way, so that we can get the full benefit of the changes we're making and making sure that our customers are very well aware and informed before we make certain changes so that they can make adjustments not only make adjustments to their supply chain strategies and execution, but they become aware of improvements, capacity, availability. Best example is grain. One of the reasons we think that we’re going to see some improvement in our grain and Ag/Min business is improving cycle times has allowed us to do the same amount of volume with certain customers with fewer assets. Our first choice when we look at the consequence of that is not to immediately go cut up cars and go to the scrap yard is to say can we fill that capacity with additional volume and go out and try to sell that capacity, take advantage of our improved performance and shorten cycle times. And as you can expect, it's not…

All right. That’s great. Thanks, Pat. I appreciate the comprehensive response there.

We got way too comprehensive answers here so …

That was a good one. I appreciate it. The shorter question follow-up for Mike and Mike, we’ve seen volumes come down from 3% to 4% to flat to possibly down, but the revenue guidance stayed the same. I can understand the mixed shift and some of that accelerating in the back half of the year, but as I look at the change in IEPS and more revenue, fuel surcharge revenue going from the top line, it looks might -- that might be 2 percentage points. I don’t know if you could help put some context around there. How much of revenue guide staying the same is really from the mix shift which we’ve seen through the first half of the year and how much from the change and how fuel surcharge is being pushed through the geography of the financial statement? Thank you.

So I think revenue is going to be driven by changes in core pricing. Changes in fuel related expenses and then, of course, changes in volume. With respect to the volume, one other things to keep in mind is that the intermodal volume is disproportionate compared to the revenue. So for example, if I were looking at my volume numbers, you might see that 45% of our volumes are related to intermodal business but only 15% of our revenues are related to intermodal business. So there's a very disproportionate impact on volume and revenue. And I think that's what you're seeing the revenue continues to be higher even though we decreased our overall volume forecast. Does that help?

Yes, and just maybe to clarify, the fuel surcharge in the slide that Mike Upchurch had about how that impacts the top line. I don’t know if that was another kind of factor to consider here?

Yes, that’s what we try to do with the last column on slide 17 is to give you an estimate of what the future quarters might look like. Obviously, we're not talking about what the quarterly total revenues are, so I’m going to stay away from percentages, but I’m sure you can do those calculations with your model, we are kind of looking at that $12.8 million.

Okay. Thanks. That helps. I appreciate it.

The next question comes from Ken Hoexter of Bank of America Merrill Lynch. Please go ahead.

Hey, great. Good morning and solid job on the improving PSR results. Great to see. Just on -- Mike, maybe on the $51 million charge, maybe you can kind of delve into that, talk to us what that’s for, given that you had a two quarters in a row now. You mentioned they may continue -- this is, I guess, not really typical for rails adopting PSR to take such charges, but I know historically you’ve been a little different given your leases and some of the things you’ve been trapped in. So maybe talk about what that generates for you and what that’s contributing from?

Yes, Ken, the charge in the second quarter was predominantly related to locomotives and freight cars that we no longer need in our business, so we will be disposing those either selling or scrapping those. I don't think the fact that we’ve taken two charges is unusual. And I think there could be another one coming, sometime in the third or fourth quarter. We will continue to make decisions about equipment. We will continue to be making decisions about number of resources we need to move trains as we go through the train consolidation and the service plan redesign.

I guess just trying to clarify that others have kind of just parked locomotives, is this getting rid of leases that you’ve had or is -- I just want to understand what the charge as opposed to just parking appointment [ph]?

It's writing off the net book value of the equipment that we're no longer going to need.

And I think the sequence that we've gone through, Ken, in the case locomotives, again we take an action, we reduce train starts, we do something that we think is going to free up capacity and reduce congestion. We parked the assets for a period of time and then once we sort of become convinced that change is going to stick, we sell them, scrap them, get rid of them, they’re gone. And we've sold quite a few of the locomotives and the impairment charge I think relates to those assets that we have maybe gone through that cycle of parking for a while and then conclude that they’re no longer necessary and actually get rid of them.

Okay. I don’t know I would presume that helps your DNA through there. Just a follow-up on the train length, I guess, Sameh, you talked about maybe lengthening train, target of 6,000 feet, is there something you need to invest more on sidings in Mexico or the U.S side? Is that something that that's your goal because that's what your network is designed for, maybe talk about the potential that’s increased that train length size?

From a -- Ken, from a siding lengths, we are okay, but we still have a lot of very short trains in Mexico. In the U.S the train lengths is very decent. Grain trains, coal trains, manifest trains are very nice and quite long and the tonnage is heavy, which is the way you want it to be. In Mexico, we have some very, very short trains and we see them every day, particularly at the endpoints of the network like Lazaro and Toluca and some of these locations because the way our structure of trains is, we drop-off a lot of blocks until we get to the endpoint and then if the train becomes short. And then when it departs in the opposite direction, it starts short and then it picks up a lot of traffic. So in the new design we are going to look at this to see how can we increase the length even at the endpoints of the network. So it's more of a design issue, Ken, than a sidings issue.

Ken, I would add just a little color. Our infrastructure is in good shape for that. I think as we started this process 6,000 was the target. And as we get into more of the TSP definition and redesign and whiteboarding as Sameh mentioned here in the second half of the year, I think your targets for next year will be above that. So I think that was the starting point for us to say, here is opportunities we see in these commodities, I will say it again with Mexico intermodal manifest products. We know we have opportunity. As we get through the whiteboard exercise I'll be very surprised if we don't have more opportunities than that, but the infrastructure we have is fine to handle that.

Wonderful. I appreciate the time. I feel like I’m giving you guys short answers. Thank you.

The next question comes from Scott Group of Wolfe research. Please go ahead.

Hey, thanks. Good morning, guys. Almost good afternoon. The guide -- the long-term guide sort of implies around a 150 basis points on margin improvement a year. Do you think we get that in the second half, Mike or is the fuel headwinds sort of too much to overcome? And if we don't get that for 150 for '19, do we have visibility at this point to over 150 for next year?

Well, I think if you're asking can the back half of 2019 be better than the first half? Yes, we think so. With respect to our longer term guidance, you can kind of do the math getting into low 60s. Yes, the 80 basis point headwind on the IEPS and then you can do the math on what that requires on an annual basis, but if you think about what we've done through normal operation this year in the first six months, we are about a 160 basis points better than a year-ago.

Let me ask this differently. And is it fair that we are changing the guide just six months in that we wouldn't be sort of improving the OR guidance if it was going to be about a 2021 step function. We got to have some confidence about more of a step function coming sooner than later, is that fair, Mike?

Well, we wouldn’t put the guidance out if we didn’t have some confidence in that. I maybe take you back to our January discussion around how we set this. We were barely a month into the process and so shouldn’t be very surprising that we are seeing bigger and bigger savings opportunities as we move through this. But we do still have things like PTC headwinds that we're trying to overcome in 2019 that won't be there in 2020 and 2021. So all along, our guidance had been the first year improvement may not be as good as the second and third year improvement.

Okay, makes sense to me. Just real quick. I see, Sameh, you've got a slide, we’ve taken 7% of the cars out, we’ve line of sight to another 3%. The locos you've taken 12% out, what do you have line of sight to there for incremental locos?

The -- it will depend a lot on the revenue. I mean we -- like Pat mentioned a number of times, we are hoping that the improved service, which is palpable and our customer are telling us that they see the improvement in service, that will generate more business. As a matter of fact, I think on the commercial call, Mike, this week or last week we won back the customer. The customer came back to us because of improved service. So if we improve service that will have an impact on how many -- how we will size our assets. Like Pat said, we would love to keep the remaining assets that we have and use some for absorbing more revenue.

As you know, it's easier to get line of sight on cars because that tends to relate to specific customers or commodities or aspects of our business. Locomotives reduced across the entire franchising and entire portfolio, so that's why we're being a little more cautious about guiding to any further locomotive reductions.

And on the car side, we still have a lot of system intermodal cars that we have in storage. I mean, we would love to get more business and use them for that.

Okay. Thanks for the time, guys.

Okay.

The next question comes from Bascome Majors of Susquehanna. Please go ahead.

Yes, thanks. You talked a little bit about attrition earlier. I don't think you gave an attrition rate for the business right now. Can you talk about the kind of inherent attrition rate in the U.S and Mexico and where it's tracking today?

It's kind of 6%, 7% normal attrition.

Is that the same on both sides of the border?

That I don't know. I just know overall.

All right. And on CapEx, Mike you talked about 18% of revenues feeling like the right level when we get beyond this year. Historically, you've done a lot of chunky coinvestment projects to grow the business with some of your customers. Would that include those kinds of projects? And regardless of that answer, do you have a line of sight into anything like that coming up next year or the year after? Thank you.

Yes, sitting here today, we don't have big projects like the Sasol if that's what you're referring to. If those opportunities come our way, we will take a look at them and see whether it makes sense to invest. But no, there's nothing of that scale built into the 2020, 2021 CapEx to revenue guidance that we've provided.

Thank you.

The next question comes from Brandon Oglenski of Barclays. Please go ahead.

Good morning. This is David Zazula on for Brandon. Thanks for taking my question. Maybe for Mike, you guys had an interchange partner go on media yesterday ordering passage of the USMCA. Just wondering if you could comment a little bit on how you think the potential added foreign investment might impact flows on the railroad and how that could affect your operational and capital planning?

I will take that, and -- yes, we are very much in support of USMCA. It's something that's very important to our company, our customers, our communities. And I've been quite vocal in both Washington and Mexico City supporting the passage of that trade agreement. In spite of the uncertainty of USMCA and for the last couple of years, look back over the last several quarters, we've seen just exceptional growth in our cross-border volumes. We do feel that the cloud of uncertainty has curtailed investments even though some of the data that’s published about direct foreign investment in Mexico continues to increase. We think that there are investments that maybe companies have been considering that they've held off or delayed because of concern about the passage of the trade agreement. I've gotten out of the business of predicting what Congress will do a long time ago, feel like there is no reason that this trade agreements should not be approved. It's certainly better than NAFTA and it's way better than no trade agreement and we will continue to be involved in trying to influence the outcome in the direction of the debate and hope to have some resolution on that in the next, probably not until after the recess in the U.S. Congress, but hopefully by the end of the year.

Great. Thanks.

This concludes our question-and-answer session. I would like to turn the conference back over to Pat Ottensmeyer for closing remarks.

Okay. Well we will -- I will wrap up very quickly. Thank you for your time and attention and when we do our next shareholder and investor survey, please give us high marks for comprehensiveness of answers. Thank you very much and we will be back with you in 90 days.

The conference has now concluded. Thank you for attending today’s presentation. You may now disconnect.