Canadian Pacific Kansas City Limited

Good morning. My name is Jason and I will be your conference operator today. At this time, I would like to welcome everyone to Canadian Pacific's second quarter 2020 conference call. The slides accompanying today's call are available at www.cpr.ca. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. I would now like to introduce Megan Albiston, AVP Investor Relations and Pensions, to begin the conference.

Thank you, Jason. Good morning, everyone, and thank you for joining us today. Before we begin, I want to remind you that today's presentation contains forward-looking information and that actual results may differ materially. The risks, uncertainties, and other factors that could influence actual results are described on slide two in our press release and in the MD&A filed with Canadian and U.S. regulators. This presentation also contains non-GAAP measures, which are outlined on slide three. With me here today is Keith Creel, our President and CEO, Nadeem Vellani, Executive Vice President and Chief Financial Officer, and John Brooks, Executive Vice President and Chief Marketing Officer. The formal remarks will be followed by Q&A, and in the interest of time, we'd appreciate if you could limit your questions to one, and the Investor Relations Department would be happy to follow up with you afterwards for any follow-up questions. It's now my pleasure to introduce Mr. Keith Creel.

Thanks, Megan. Good morning. Beautiful day in Calgary. Let me start first and foremost. I'd be remiss not to begin my comments by applauding and continuing to thank our CP family. 12,000 strong, they continue to serve communities throughout Canada and the U.S. with a tremendous amount of pride. And it's that pride and it's our culture of accountability and performance that continue to fuel this unique performance that we produced at CP for our customers and for our shareholders. I can tell you as a leader, it's my honor to be able to serve with each of these men and women that make up our CP family every day. These employees are the true heroes that have been supplying and ensuring the supplies that people are depending upon are delivered. Rest assured, that's a responsibility that none of us take lightly. And I'm grateful to these employees and their union leaders for their continued strength and commitment to delivering for the North American economy, especially during this extraordinary time of need. So, under the guidance and the results, I can tell you we've consistently said that PSR is an operating model that works both on the upside and on the downside. And I'm sure that you would agree that today's results are a strong testament to that. In spite of the rapid change in volume, Mark and the operating team rose to the challenge throughout the quarter. They remained nimble. They adjusted resources and lockstep with our demand from the beginning to the end. This is what has enabled our strong operating performance across the board. Train weights and lengths, all-time record levels up 7% and 8% respectively. Locomotive productivity, again, an all-time best level, up 2% versus last year, full efficiency, a Q2 record, and a second-best quarter record for the company at 0.92 gallons per 1,000 GTMs, all of which enabled a record Q2 operating ratio of 57%. And as John will tell you as he provides color into the markets, This performance enabled us to set a number of new records for our grain and our potash customers that we're extremely proud of. You'll also note in our press release today that we provided updated guidance due to the strong performance. To date, we've guided a positive earnings growth for the year. We're following through on our commitment also that we made on our last earnings call, restarting our buyback and increasing our dividend. And as I said on our last call, we assured you that CP would emerge this pandemic a stronger company. Then we went in, and that's exactly what's happening. And it's not just the operating team that's moving the trains day in and day out. It's the folks that are working at home as well, the full team. This is a full team event. The men and women working from their homes have not been resting on their laurels, rest assured. We've been keeping constructive tension throughout the entire organization. We've challenged all of our people, especially those that are working at home, to find new and more innovative ways to work, focus on people. We focused on leadership. development and market development. I challenge John and the marketing team, sales team to get closer to the customer, to mine for opportunities, to drive additional volumes to the railroad, to be a problem solver, a transportation solution enabler for our customers in these tough times. We challenge the executive leadership team, get out of the office, get on the network, get on the ground. There's never been a better time to spend time with our people, the men and women, the heroes that are moving this traffic day in and day out. not only learn about the business, but let them know how much we appreciate what they're doing day in and day out when they come to work to protect the livelihood of others. Collectively also, we double down on leadership development. That's a legacy that I certainly intend to leave at this company. In order for this company to continue to improve, our leaders have to improve, and as the leaders improve, the company gets stronger, and that's the key to sustainability. That's the key to continuing and sustaining this very unique and special culture of accountability, this culture of performance that fuels these results and that delivers our freight to our customers day in and day out. It's the key to it, and we'll continue to develop those leaders through the training, the investment in each individual so they can realize their best potential and CP can realize its best potential. So the team's getting stronger. We're getting close to our customer. We're developing stronger leaders, and we're becoming better railroaders. It's fair to say we've been on the offense, not on the defense through these challenging and turbulent times. So with that said, now I'm going to turn it over to John to provide a bit more color on the markets.

All right. Thank you, Keith, and good morning, everyone. So total revenues were down 9% this quarter to $1.8 billion. RTMs were down 10%. FX was up 2%. Well, fuel is down 3%. I'll briefly highlight our second quarter performance and provide you guys some color on our major lines of business. I'll speak to the results on a currency-adjusted basis. So starting with grain, volumes were up 8% on the quarter, revenues up 3%. I want to start by echoing Keith's comments and once again congratulating the CP team and our grain customers for delivering another tonnage record for Canadian grain at 8.4 million metric tons. This beat our previous all-time record in Q4 2019 by 500,000 tons and marked the third consecutive record quarter for Canadian grain. The results are a testament to the benefit of our Cover Hopper investment and the partnerships with our customers who are also investing hundreds of millions of dollars on the CP Grain franchise through expansions and new developments to enable our unique 8,500-foot high-efficiency train product. The proof is in the incremental 2.5 million metric tons of grain we have moved this crop year, all while leveraging existing crews, train starts, and network capacity. We are excited about recent announcements. Viterra's work on the South Shore at the Port of Vancouver to enhance their terminals, along with the recent announcement of a new Greenfield high-throughput elevator exclusive on CP and Rosser Manitoba, both of which will be capable of handling our 8,500 foot trains. I'm also extremely pleased with the performance at Alliance Grain Terminals and their decision to move to a 24-7 operation on the Vancouver South Shore exclusively served by CP. And to service this export terminal, Patterson Grain, a pioneer of our 8,500 foot model, will be undergoing three more expansions at its elevators to support this new terminal throughput capacity. Now, looking ahead, we expect grain to be busy the remainder of the year. Carryout from this crop is expected to be close to average, and the 2021 crop is maturing well, and our customers are expecting it to be greater than 70 million metric tons. On the potash front, volumes and revenues were up 5%. The strength we expected in potash materialized in the quarter. On the export side, continued strong collaboration and execution with the Campotex team, including increasing train lengths to 188 cars to their Portland terminal, supported a record performance in Q2. On the domestic side, after consecutive poor application seasons due to weather, we had excellent conditions this spring and delivered strong service for our shippers. The outlook for potash remains positive and I expect double digit growth as demand remains high and back half comps are favorable. We continue to see strong resiliency of the commodities across our agricultural franchise that make up greater than 30% of our book. I expect momentum to continue that we've seen year to date to continue into the back half of the year. Moving on to coal, revenues were down 24% while volumes were down 21% on the quarter. Canadian coal volumes declined as a result of softer demand related to COVID, production challenges at the mines, and limited port capacity due to the ongoing expansion at the Neptune terminal. We expect 2020 tonnage to be lower than 2019, and Neptune is expected to be shut down through the end of September. The energy chemicals plastics portfolio saw a revenue decline of 3%, while volumes declined 35%. The significant difference between revenue and volume is driven by crude liquidated damages. These contracts did exactly what we told you and designed them to do. They protected CP from the inherent volatility in crude by rail volumes. Crude volumes fell through Q2 to approximately 8,000 car loads, down about 70% year over year. Our guidance assumes minimal crude volumes through the back half of the year. The continued volatility in the crude market only strengthens our conviction in the stability offered by the diluent recovery unit located exclusively on CP in Hardesty, Alberta. Construction is well underway and we expect completion by mid-year 21. Now turning to MMC, Revenues declined 37% and volumes were down 35%. This was all driven by frac sand as it was a big decliner in the quarter as a result of crude market declines and resulting shut-in production. Steel, aggregates, other construction inputs, which were all certainly challenged by the pandemic, are expected to gradually recover through Q3 as industrial and construction sectors reopen. Automotive revenues were down 68%, while volumes were down 70% on the quarter due to the North American manufacturing shutdown. Since the restart, restocking efforts and vehicle sales have outpaced our partners' expectations. We have a lot of positive momentum right now in our auto space as we move into Q3, as we welcome two new customers aboard. We welcome FCA, at our Calgary and Vancouver auto compounds beginning July 1st, and Globus comes on board beginning September 1st. We continue to utilize our unique land holdings to provide strategic, purpose-built compounds for our partners. Through the execution of our automotive playbook, we have launched four new compounds across our network, giving CP customers more optionality and unmatched local market assets. Finally, moving on to intermodal, quarterly volumes were down 7% as a result of overall softer consumer demand across North America. On the domestic intermodal front, we performed well in the quarter in our movement of essential goods, and our refrigerator demand has since returned to pre-pandemic levels. From our trough point to the last week in June, we've seen a 43% increase in RTMs from our temperature-controlled Tempro product. On the retail side of our business, we've had strong performances from our leading retail partners as we move through the quarter with a nearly 50% surge in RTMs since our trough. On the international franchise, it remained resilient. We did not see the expected volume of blank sailings which helped us stay close to flat year over year. Now looking forward, I am extremely excited about our new access through the CMQ to the Port of St. John. This port has the potential to be the crown jewel of Eastern Atlantic ports through our strong partnerships with DP World, New Brunswick, and the business partners throughout that region. The Port of St. John offers a low-cost existing capacity that is undergoing over a $200 million modernization project. This project, combined with CP's shortest route and fastest service to the West, offers our customers a new, compelling, competitive Eastern Canadian option. So let me close by saying, as Keith said, the sales and marketing team and this company has not been resting on our laurels. We've had the team out cold calling, sales blitzing territories on our network, building new relationships, and finding outlets for our customers. That's the PSR culture that we have in the sales and marketing team. I'm pleased with how the team has adapted, and we have a strong pipeline of broad-based opportunities for years to come. So look, the next several weeks will present challenges as it relates to comps, given our strong industry-leading performance last year, but the volume environment continues to improve. As we look forward, we will continue with our disciplined approach to picking our partners, executing our playbooks, enabling us to outperform the industry. With that, I'll pass it over to Nadine.

Great. Thanks, John, and good morning. As Keith and John mentioned, this has been a challenging quarter, but this team of railroaders once again rose to the challenge, as demonstrated by our industry-leading operating results. As with Q1, I surprised people with a commitment to a sub-60OR, but our exceptional team went out and managed to exceed my high expectations once again. The operating ratio decreased 140 basis points to 57%, which is a new CP second quarter record. I've been in this industry for 22 years, and this quarter is a significant milestone. When you can report a 57% operating ratio in a quarter that volumes down this significantly, it gives me a high level of confidence to eventually achieving a mid-50s OR on an annual basis and continue to widen the gap with our Canadian peer. Moving on to a few of the more notable items on the expense side, I'll be speaking to the operating results on an FX-adjusted basis. Comp and benefits expense was down 11%, or $41 million versus last year. The primary drivers of the decrease were 10% lower headcount as we furloughed employees and significant efficiency gains from lower crew starts and increased train waits. Cost control you're seeing is truly structural. Stock-based comp wasn't a material headwind, but on an annual basis at approximately $40 million, definitely weighed on expense. We continue to deal with the pension headwind of $8 million a quarter, as well as continue to accrue incentive compensation based on our strong results here to date. Fuel expense decreased $112 million as a result of a 38% decrease in the price paid year over year. lower volume, and the benefit from a $13 million lag in our fuel surcharge program in Q2, which we did not expect to replicate in Q3. A record Q2 fuel efficiency also played a big role. This also marked our second best ever quarterly fuel efficiency. Our investment in modernizing locomotives, fuel trip optimizer, and the 8,500-foot grain model continue to drive our fuel efficiency 14% better than the Class I average. Since 1990, CP has reduced its locomotive greenhouse gas intensity by 42%, avoiding over 31 million metric tons of carbon. Depreciation expense was $195 million, an increase of 6% as a result of a higher asset base. Purchase services was $266 million, relatively flat on the quarter despite lapping a $17 million headwind, from a land sale in 2019 and approximately $10 million in higher casualty costs year over year. The team effectively controlled spend and adapted to the current volume environment. This is a testament to what a true PSR railroad is. Mark Redd and the operating team worked closely with John's team, Mike Foran and the asset management team, and my finance team to achieve these results. This does not happen by accident. Moving below the line, Other components of net periodic benefit recovery were negatively impacted $12 million, or 12%, primarily due to a lower discount rate. Interest expense was up 5% as a result of foreign exchange on U.S. dollar debt. Income tax expense increased $65 million, or 52%, primarily driven by a recovery in Q2 2019 related to changes in the Alberta corporate tax rate. We now expect an effective tax rate of approximately 24.8% for the year. Rounding out the income statement, adjusted diluted EPS declined 5% in the quarter. Moving on to the free cash statement, cash from operations increased 17% on the quarter. We are continuing to adapt in real time as volumes change and the economy moves forward. We are stretching our capital dollars out to greater efficiency. In fact, we experienced all-time highs for engineering efficiency as measured by block time availability. This quarter, our engineering crews had only six zero block days, which are days where they could not access the track, as compared to 30 zero block days in Q2 2019. This shows our engineering teams were efficiently able to complete their work and trains were able to run on schedule. Year-to-date, our capital efficiency has improved 19%. So it's a huge credit to the operating teams and the engineering teams for working collaboratively to enable us to achieve significant capital efficiencies. We remain committed to our $1.6 billion of capital spend for the year and are managing the capital envelope for the long-term benefit of the company. Rest assured, we continue to maintain discipline on capital deployment as evidenced by our adjusted return on invested capital of 17.1%. As a final note, We continue to be in a position of strength from a liquidity perspective. As of June 30, our 1.3 billion US revolver was undrawn, and we had no commercial paper outstanding. We are proactively managing liquidity and feel confident in our decision to increase the dividend by approximately 15%, which we announced yesterday, on our path to an adjusted payout ratio of 25 to 30%. Since 2015, we have led the industry in dividend growth with a compound annual growth rate of 17%. We will continue to balance our shareholder returns and have restarted the buyback program, which is about 40% complete. We'll remain opportunistic and disciplined on the buyback. As Keith spoke to, our strong performance year to date and our increased clarity on the back half of the year have given us the confidence to increase our guidance to EPS growth for the year. The PSR model is one that truly works in any environment, and I can't think of any better proof point than our performance this quarter. I'm confident that in 2020 will be our fourth consecutive year leading the industry in train accident ratio, EPS growth, and return on invested capital. With that, I'll turn it back over to Keith to wrap this up.

Okay, thank you, Nadim and John, for the color, and I think we'll save the balance of our time. I'm going to turn it over to the operator to open up for questions before we do the discussion.

At this time, if you would like to ask a question, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. As previously highlighted, please limit your questions to one. There will be a brief pause while we compile the Q&A roster. Your first question comes from the line of John Chappell from Evercore ISI. Your line is open.

Thank you. Good morning, everyone. Good morning. John Owen. John, I wanted to ask you about some of the commentary you made on the in modal and the auto side. Clearly, inventories in North America are very low. The blank sailings are much lower, if not reversing, and the auto plants are kind of cranking. When you speak to your customers, how much of the restocking seems to be a 3Q event only, and how do they feel about the duration of potentially the entire second half of the year on both of those business segments?

Yeah, so maybe a couple of comments on that, John. You know, look, like everybody else, we're continuing to navigate this uncertainty. So the auto manufacturers, the retailers, it's, you know, if you know the answer of what this pandemic looks like over the next six months, you know, we're all sort of estimating and guessing based on that. Now, that being said, we have definitely seen those areas ramp up. And I think our expectation is we're going to continue to see that, you know, stabilize probably through Q3 and then maintain that sort of pace or that gentle recovery as we move into Q4. Certainly in the auto space right now, we're seeing an initial surge. And that probably doesn't continue. But, you know, don't forget, we are going to see a nice bump the back half of this quarter as we see Glovis join our auto franchise, which is going to be a significant tailwind for us.

That's great. Thank you for the feedback.

Your next question comes from the line of Tom Wadewitz from UBS. Your line is open.

Yeah, good morning and congratulations on a really strong performance in the quarter. Wanted to see if you could offer some thoughts, you know, perhaps, Keith, on just the schedule changes that you made in order to achieve the 8% increase in training length and how you would think about operating leverage given that you've already expanded training length. Do you, you know, do you expect that number to keep going up as volumes come back? You know, any thoughts about kind of, you know, volumes coming back to unit train versus car load? How do we think about that operating leverage, given that you did so well in the quarter with expanding train links?

Well, listen, let me start with probably a pretty known fact, at least in my company, our company. I'm a pretty demanding person, and I've got pretty high expectations and got a lot of confidence in Mark and the team. You know, they were challenged with, take our plan, which obviously was built for a different demand level, and adjust it and tweak it. And as you do that and you consolidate, you get an opportunity to realize some of these synergies. So that did help with train weights. That did help with train lengths. So as the business comes back, you'll adjust some of those things, but you won't see a monumental change. I mean, you might see 1% or 2%, but the expectations aren't going to change. We become smarter as we go through these processes and we go through these challenges. Some of the things that will offset even maybe that degradation is getting a full impact of some of the operational changes we made prior to the pandemic. And I'll speak specifically to potash. You know, this time last year, or in 2019, we moved a lot of potash for Capitex. And when I say a lot, the tonnage that we moved, we moved it differently. We were running 172 car trains to Vancouver. We were running 130 car trains to Portland. Well, we've Flip that model upside down, we've taken a next step. We're running 200 car trains to Vancouver today. And in partnership with UP, we're running 180 car trains to Portland. So those incremental gains from productivity gives me the confidence that you might see a little tweaking, but you're not going to see much degradation, Tom, because of the fundamental changes we've made in the network. And that's just one story. I could get into a lot more detail. But just rest assured, you look at our track record. We challenge ourselves to get smarter every year. This is a process of continual improvement. We're eight years into PSR. This didn't need us. We understand what we're doing. It's woven into our DNA. We know where our pinch points are. And as we attack those issues and we become better leaders and better railroaders, we sustain, maintain, and continue to improve.

Your next question comes from the line of Steve Hansen from Raymond James. Your line is open.

Yeah, good morning, guys. Just a quick question for you, maybe, John, on the potash outlook. I think you described double digits through the back half here. Some of the larger exporters have signed contracts through October. I'm just curious if you have any visibility right through the end of the year when the comps really do start getting easier. Just any context around sort of that cadence as to how that will continue to flow would be great. Thanks.

Yeah, Steve. So if you think back to last year, we saw a little bit of a decline start to take place in August. And then September, you saw a pretty dramatic fall off. So I'm confident we're going to see a pretty big spike as you hit September and certainly October. Now, discussions with Campatex, I think they remain very bullish on the marketplace. You're right. There are some contract extensions they have to work through that will cover off the very back half of the year. But, you know, like anything, I think they've been resilient as they've worked through those negotiations with China. They've opened up new markets and strengthened relationships into other areas such as India. Yeah. And so I think they remain quite optimistic that this thing is going to remain strong right through the end of the year, Steve. Appreciate it, guys. Great quarter. Thanks.

Your next question comes from the line of Ravi Shankar from Morgan Stanley. Your line is open.

Thanks, Morgan, everyone. But, Keith and Dean, a quarter ago, if I had offered you earnings down 5% this quarter, I suspect you'd have taken that with both hands. So if we can just take a step back here and kind of look at this performance in the context of what is to come, I mean, do we think of this as you guys just performing remarkably well to limit the downside in an extremely challenging quarter? Or do we say, you know, hey, they did a 57 OR in a quarter like this. which means if the cadence of the volume recovery that we saw in the second half of June continues through 3Q, 4Q, and 21, that mid-50s OR is something that can be achievable as early as next year.

Well, I think it was a phenomenal quarter. I think there was nothing unique about it. This is, I mean, when Keith built this team, And he took over as CEO. I mean, this has been a long time coming. This wasn't just an overnight kind of fix. This is building the team, building beyond the people that you know. You know, we all have strong benches behind us with the best team in the industry. And so, you know, we'll take what the environment gives. And I think we're very proactive and very collaborative and can adjust, obviously, as you saw this quarter, to what the volume environment is. But when we look at what we have ahead of us, I mean, we're probably, as John would say, as bullish around our revenue outlook over the next two years as we've ever been. And from a cost point of view, why I say this is a bit of a milestone quarter is when our operating team and our markets asset management team and our finance team and so forth can put together a adjust the OR and adjust our expenses to overcome this kind of headwind in a downside scenario, as we saw, to your point, on the operating leverage on the upside, it creates kind of a new environment and a new perspective on what you can deliver. Now, do I think we can hit a mid-50s OR next year? I don't want to say that right now in the middle of a pandemic in July of 2020, but I certainly have a lot of confidence that we will continue to improve our OR. We'll have the best OR in the industry this year. We have the potential to continue and improve in 2021 and 2022. And so I feel good about, I feel great about our revenue story. I feel very good about our cost story. I feel excellent about our free cash conversion story, our return on invested capital. So I think every bucket that when I look at the performance of what this outlook of this company can deliver, It's extremely positive.

Your next question comes from the line of Fadi Shamoon from BMO. Your line is open.

Yes, thank you. Good morning, everyone. So just a question on the comment you made around St. John and the opportunity there. I mean, you're kind of leaning on St. John. Your competitor is leaning on a different port out east. I just wanted to kind of understand from your perspective, what does the supply chain look like for you coming through St. John, like kind of where is the originating market that would be using St. John, and where would that traffic be going? And where do you think this opportunity kind of materializes from a revenue perspective? You know, if this is 2021 or 2022 kind of opportunity that you see it.

Let me, let me say a couple of things at a high level and I'll turn it over to John to provide some color. But if I'm going to lean on a port that's high water, I'm going to lean on the one that's closest to market. There's a 200 mile route advantage. You take a railroad that gets you there line of sight as a crow flies faster on our best day. The service is unparalleled. And we'll create the market with the service, so it's going to come from all commodities. If I look forward over 21 and 22, I feel confident saying, based on what we know now and the opportunities that are in development, these aren't conceptual ideas. These are substantive steps that are being taken, business that's been won, business that's being planned, infrastructure that's being invested. collaborating with the Port of St. John, collaborating with the province of New Brunswick, collaborating with our customers. You know, we've got a space out there that had one, I guess two competitive options. You had our competitor or you had the truck. And I can tell you there's a lot of trucks on the road. And when you get to something that's truck-like competitive from a service standpoint and time, and you have the track record of reliability, this team is established. Customers We'll step into those solutions with you. So it's across the board. You know, this time next year or by the end of 2021, I'm convicted and I'd be extremely disappointed if we wouldn't be celebrating a steamship line that's got a flag flying in the Port of St. John. I'll tell you, I'd be disappointed given the things that are developing if we don't have automobiles that are moving from a domestic destination in the Port of St. John. I would tell you I would be disappointed if we're not moving a whole lot more forest products in LPG, in fuels. It's just across-the-board opportunity. You're interjecting a best-in-class railway competition and great transportation solutions that get our customers' products to the market faster and allow them to compete to win more market share. And that's a powerful recipe for success. So I hope you Since my conviction, when we say we're going to do something, we're going to do it at this company. And I'm not saying it because we think it can happen. I say it because we believe it and we're working toward it and we'll execute. And by the end of 2022, that little $40 million railroad that we bought is going to be well north of $100 million in annual revenue in U.S. dollars. It's CP margins. John?

You know what, Patty? Keith said it well. I might add that You know, we're excited about the prospects of seeing manufacturing and of consumer goods shift more and more to places like Southeast Asia and India and South America and potentially even nearshoring opportunities. Port and State Johnson sets us up well for, I think, all those categories. And let's not forget the CMQ also gets us access into Sears Port, Maine, a second port over there that I frankly believe we haven't scratched the surface in terms of what those opportunities will look like. And as you know and I've talked about in the past, we've built a lot of – hit a lot of singles and doubles over these last two, three years with our short-line partners. And that part of the U.S. opens up a whole new category of opportunities in that bucket. that the merchandise team, Colby Bollard and his team are attacking vigorously. So, you know, beyond all the things Keith spoke about, to say that we're bullish on that opportunity is an understatement.

Your next question comes from the line of Konar Gupta from Scotiabank. Your line is open.

Good morning, everyone, and thanks for taking my question. Just wanted to understand some key assumptions behind your revised guidance for EPS growth for the full year, especially for operating ratio. I guess you have some relatively tougher comps in the back half here, and then the volumes are obviously still kind of downwards this last year. What kind of volume environment do you expect in the second half, especially for crude by rail and fraction assumptions there? Thanks.

So I think as John mentioned, there's not a lot outlook on crude by rail that we've baked into our guidance. So it's very minimal volumes. We've kept our guidance on RCMs down 5%. You know, certainly we have very difficult comps in the first half of Q3, which you're seeing we're down about 10, 11%, which is as expected as actually we're performing a bit stronger so far in Q3 than we originally thought. So, it's really around the cost side. I mean, we're performing exceptionally well on the operating performance led by Mark and his team, and the takeout opportunities are very strong, and that's what's driving the upside on the EPS.

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

Hey, Greg. Thanks. Good morning. Yeah, John, maybe you could hit on peak season intermodal. You know, obviously we've seen some of those numbers look a little bit better, but I guess it's a little difficult to tell sort of where inventories are and sort of what the confidence level is in consumer demand as we go through the rest of the year. So any kind of colors you can kind of give or dig a little bit deeper in terms of what you're hearing from the customers, how they might be setting up for later this year on intermodal.

On the domestic side, Chris?

International.

International, okay. Yeah, so I think right now we are seeing the blank sailings that have been laid out for July, August, and a little bit into September. We're seeing our steamship lines sort of methodically pull those back. I was looking at coming weeks and the next two-week schedule of what's on the water and And I say overall volumes look strong and encouraging. You know, look, I still think there's a lot of uncertainty in this space, you know, sort of depending to your point exactly what the consumer does and how this pandemic either we continue to push forward with the opening of the retails and all the sectors that across North America. But, you know, I think our our forecast right now is we continue to see, I would say a little bit of a surge here continue in q3. And then maybe a little bit of normalization as you move back in into q4. But, you know, that's going to all be dependent on, on what we see happen with this pandemic.

Your next question comes from the line of Walter Spracklin from RBC Capital Markets. Please go ahead.

Thanks very much. Good morning, everyone. So I guess my question is for John here on yields going into next year. Obviously, you have a lot of moving parts here with some of your line items, so I just wanted to make sure I'm getting the yield right. And perhaps if I could frame the question relative to your core price, do you expect yield to be above or below 1%, or additive or negative on core price. I'm referring here to you've got the grain minimum revenue cap that's coming down for you. You've got your tech volumes switching over. You've got liquidated damages that might come off next year, maybe a year later. So all those moving parts, I'm just looking to see if you see yield as enhancing or detrimental to your core price for next year.

Well, I mean, a core strategy has been sort of picking our partners and maximizing those, the leverage of, you know, whether Keith spoke to train lengths or capacity on existing trains. So I think, you know, both our initial responses, we continue to see that margin opportunity out there. I can tell you on the pricing front, I've been very pleased with how we've performed the first half of this year, despite all the uncertainty. And trust me, it's been tough discussions in some cases with customers given the challenges they've been facing. But I'll remind you, you know, my sales team is a large part of their compensation is tied to price discipline, and we've been able to deliver. I'll go on to say this. You know, as I look to the back half of the year, I'm actually pushing for price acceleration from where we're at. And I think as trucking capacity continues to maybe tighten in some of these lanes and areas with recovery, also I think we're seeing discipline across the rail sector and certainly maybe some challenges as other roads try to ramp back up the volume, I think leads to an opportunity on that front.

And Walter Smadima, just to add, if you think about Next year, you know, we have a very bullish outlook as far as our automotive volumes, which is going to be beneficial to overall yield. As some of the tech revenues roll off, that's going to be beneficial to yield. So net-net, you know, I think, you know, it's a long way from now, but certainly I don't see too much detrimental impact on yield to your question.

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

Great. Good morning and congrats on the great operating performance. Really great to see and impressive. Just maybe talk about the structural change out of your downturn. Your peer talked about closing some yards or facilities through this downturn. Just want to see if you've done anything like that. And really thinking of this as a CapEx question, I guess is there room to increase free cash flow further given the improvement in train lengths and weights? Are you still moving to upgrade sidings? Is the, you know, capex still? Any thoughts on that given the near 20% of revenues?

Ken, let me – I'll say at a very high level, part of what we do, pandemic or non-pandemic, and have been doing at this company is always rationalizing and driving for productivity improvement. So as far as any quantum changes shutting structural yards down, you know, we've gone through that. several years ago, but what we do today and what Mark and the team have done, when you respond like we've responded, is you consolidate traffic, you bring it into terminals where it's best served at your lowest cost, your most productive facility. So in case in point here in Calgary, we've spent a lot of money over the last, I guess it just came online in 2019, actually redoing our yard. So that was a hump yard that was closed down back when we first started our PSR journey in 2012. We may do with what we have because we had other larger priorities optimizing the network, but we came back to Calgary and said, listen, Calgary is the place to switch cars. It's not do all this extensive switching in outside satellite locations. Let's consolidate, let's invest, let's create a very productive facility, which is what we've done and which is what Mark has been optimizing in 2020 through this pandemic. So that's been a blessing for us. Structurally, that's a change that we'll retain. And again, we're becoming better as we evolve and we increase train links. Even to the question I was asked earlier, I think about our grain program. That's structural for this company. We led that innovation in this industry in the Canadian space, striving to an 8,500-foot operating model. G3, the terminal that was built, was built to facilitate that on the North Shore. We've got 15% of our elevators now that can launch 8,500-foot grain trains. We've got A fleet that's being modernized. We're up, by the end of this year, we'll be in excess of 3,000 of those dusting class cars that are coming out of Hamilton, Ontario, that allow us to haul more grain per car, shorter length of cars that drive productivity. So the structural changes that you see in our performance will continue and be baked in. And we'll realize full year and get more of a mix as we go forward on this 8,500-foot grain production. program will be 30% of our elevators by the end of this year, and the work continues. The productivity and the increases in capacity on the South Shore to match that, as well as G3 on the North Shore, I'm just very bullish about our opportunities to make these margins, to make these efficiencies stick. So again, high expectations, strong conviction based on our fundamentals that, you know, we're not perfect, but we're darn sure pretty educated and pretty efficient at what we do, and we'll continue to do that and do it well.

Yeah, and Ken, I'll just say on the CAPEX side, we're extremely pleased with what we've been able to deliver on, take advantage of some track time to be much more efficient, as I mentioned in my commentary. And so we're taking this unique opportunity with volumes down that we haven't seen volumes down like this in many years that we can look to build a network that is very resilient, look to build a network that can support some of the initiatives that Keith spoke to around our 8,500-foot model and so forth, initiatives that will increase the capacity and the safety of our network. And so this is something that's going to – I'll say it's going to pull forward some of those capital dollars from future years. And it's going to set us up extremely well for the rebound in the economy over the next call it 1218 months. And we can take advantage of these significant new opportunities that Keith and John have talked about. So it's a bit of a different model, but but we we tend to be a bit different. Thank you.

Thank you, Kim.

Your next question comes from the line of Benoit Poirier from Desjardins Capital Markets. Your line is open.

Yes, thank you very much, and congratulations for the very strong performance. Could you talk a little bit about the potential for further M&A on top of CMQ? And maybe a very quick question for Nadim. If he could quantify the fuel lag in Q2, that would be great. Thank you very much.

Quantify what? Fuel lag. Fuel lag. Fuel lag, I believe. Yeah, I think fuel lag was about 13 million in the quarter. That you won't see a benefit of in Q3.

Yeah, and as far as M&A, listen, right now we're focused on optimizing the CMQ. That's going to keep us busy for a little while. Certainly, I don't want to dilute our efforts there, but we always have a keen eye. If there's something that complements our network, We stick to our core fundamental strengths, which is running railroads. I don't see anything immediate that's out there, but rest assured we're going to maintain a strong balance sheet. We're going to maintain a best-in-class operating team to be able to realize the potential of our network and any other network that we might couple onto this thing. But right now there's nothing immediate, but our eyes are always open. And if it makes sense, we'll not hesitate to move.

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

Hey, thanks. Morning, guys. Morning, Scott. Nadim, any chance you can give us some just directional color on the magnitude of earnings growth you're expecting? I think first half's up 20%. Second quarter, the worst of it, only down five. So maybe just some thoughts there and then – Any thoughts on the ability to improve margins again in the third quarter? It would be great.

Thank you. I don't want to get into quarterly guidance necessarily. We do have, as I mentioned, the first half of Q3, there's a bit of tougher comps, but then it eases pretty significantly with grain coming on, assuming a decent grain crop, which we do assume. And given it was a very wet crop last year, grain didn't start moving for some time. We have very easy comps for potash as well in Q4 versus where we were a year ago. And so I think you're going to see Q4 being stronger than Q3, just assuming what we know now with how the pandemic's been reacting and how the economies have been coming back. So beyond that, as far as given, you know, operating ratio kind of OR guidance, I'd say I'd point to the same things I just mentioned, right? So, you know, you're going to see a better OR in Q4 than in Q3 for those exact reasons. I think they'll have better volume performance in Q4 than Q3. And so, you know, I've pushed the team as far as they can deliver, and they continue to surprise me. So, you know, is there... potential to continue to improve the OR, yes, I'm not going to deny that. And I'll just leave it at that, Scott.

So you could probably convict Nadim of being conservative in nature, which is healthy. But we certainly see line of sight, Scott, end of the year for margin improvement versus last year. We're not doing our job if we don't get there. There's opportunity there.

Yeah. Your next question comes from the line of Sheldon Clark from Deutsche Bank. Please go ahead.

Hey, good morning. Thanks for the question. Can you just talk about how some of the productivity initiatives that Keith highlighted have maybe trended in July as it relates to train weights and lengths and fuel efficiency? And, you know, as certain volume categories start to come back, like autos, is there a point where, you know, maybe mix becomes a little bit more challenging in terms of, you know, adding certain cars to mix manifest trains or anything along those lines?

Well, I can tell you this. It's a gift that keeps on giving. So similar metrics in July versus second quarter. I took a quick look at them this morning. RTMs down 10 points, you know, effectively 10 points versus last year as of this morning. Crew starts down almost 17%. People starts down almost 18%. train miles down almost 18%, train length up another 8%, train weight up 7%. You know, when you run the business this way and you control your assets and lockstep your demand, this is what you should expect. So as we bring back business on and these autos start to come on, we've already got a plan. We know what the plan looks like. So there'll be some transition to the plan, but you're never going to expect to see this company running short trains. We're going to look for a way to tweak. You constantly, you make a plan, you execute the plan, you tweak the plan. You communicate with your customers, you satisfy, you do what you say you're going to do, and this is just the outcome of it. You're going to get a low operating margin, you're going to get a high service offering, and when you can produce a great service at a low cost, that is a compelling competitive advantage in the marketplace that drives earnings growth. And that's what this formula is all about. It's not complicated. The complexity and the necessity comes in having the right culture to execute it. And at this company, we have it. We're not perfect, but we're getting stronger every day. You can expect to see continued operational margin improvement as well as operational performance improvement in all of our metrics. We're not going to set steel. You set steel, you get passed by.

That's not going to happen at this company.

Your next question comes from the line of David Vernon from Bernstein. Your line is open.

Hey, John or Nadine, could you give us a sense for how much liquidated damage is actually in the plan here for 2020? And then as we think about maybe that crude volume either coming back or not coming back in 2021, what does that do to the setup for the contribution from that fee revenue that you're recording this year?

So, David, I'm not going to give a specific number on the liquidated damages. What I would say is I think what you've seen over the prior quarters, if we're not moving the crude by rail, you're going to continue to see that run rate, and that moves into 2021. Now, obviously, in 2021, there'll be some natural comparables given that we're collecting liquidated damages this year. But also in that equation, David, don't forget we've got the DRU that we expect to start up mid-year, and that's going to be a significant opportunity for us as we look to the future. And the bottom line is, and I know my competitor said this and we continue to say this, I'd much rather be moving that freight So our energy team is working close with all the crude shippers and looking for that window of opportunity and when it's going to be. So we can work with Mark Redd and his team to resource up to be able to handle it in the back half of the year or in early 2021.

And David, I would just add, if we don't see this as a one-time benefit, If we saw it as a one-time benefit, we wouldn't expect margin improvement year over year to continue.

Your next question comes from the line of Brian Ossenbeck from J.P. Morgan. Please go ahead.

Hey, good morning. Thanks for taking the question. Just a quick one on crews. Given the outlook for the back half of the year and the volume on the train size and weight, Can you give us some expectation for how you see bringing back crews from furlough? I know you don't do those lightly. I was also curious to see what the availability and the callback has been, given that you and the rest of the industry were pretty flexible making sure folks were taken care of, and in exchange you're able to get some shorter callback time. So just some thoughts on the crew outlook and the recall rate in the back half of the year. Thank you.

Well, let me, you know, the crew outlook overall, we ended up, I think, at the peak. We were about system-wide, this is Canada and U.S. Unfortunately, we had about 1,200 running trades employees that were furloughed. We've called some of those back. Obviously, we'll do that in lockstep. It depends where the business is. But if I just sort of bottom line it, if we're going to be down mid-single digits, you should expect the same on a headcount standpoint at the end of the year. we'll retain some of this productivity. Obviously, we're not going to call anyone back we don't need, but we're working hard to increase and drive business through this railroad so we can get our employees back to work. We hired them. They're part of our family. I take no pride in great responsibility in the fact that we need to get those folks back to work. And what we did, I think, again, unique to CP and appropriate for CP, we decided... that the most important thing through this is to stick by our employees we have a responsibility to do as much as we possibly can to help mitigate this impact that this crisis has created for those that are that are laid off so i can't get into all the details but i can tell you with each individual union we've worked and created incentives whether it be a top-up to their unemployment insurance or whether it be a mechanism to maintain their actual medical insurance that they otherwise wouldn't have. And in exchange for that, not only do we get increased commitment because our employees know we care about them, they've also committed to come back earlier than they would otherwise in their collective agreements have required. So for instance, in Canada, running trades employee, the collective agreement gives them up to 15 days to come back. The largest percentage of those employees have committed and locked up with those increased benefits that we've given them to come back in 72 hours. So listen, this is a partnership. We're in this thing together. What I'm most proud of, in all honesty, you think about the culture in this company, you think about maybe some of the bridges that were burned, and we've talked about this in the past, and we didn't get everything right. We drove fast, hard change to turn this company around and restore its financial strength through the first four years of our turnaround. But the last three years, as much as we've been focused on growth, we've been focused on rebuilding relationships. And I can tell you this crisis has brought our employee base together. You know, we have relationships and established relationships of trust with our union leaders, with our employees, that quite frankly, in my 28 years of railroading, I've never, never seen the depth and the respect and the pride and the levels of growth that we've came in that space. Now, we're not done. And again, we're not perfect, and there's still a lot more we have to do. But rest assured, if you go out now on our property and you talk to our employees, the efforts that we've gone to protect their lives as they protect the livelihood for their families and the communities we operate in and through, we've spared no expense. We've spared no effort. We're in this with them, and they're in it with us. So I just We're going to respond. The business comes back. Our people are ready to go to work, and I'm ready to get them back as quickly as we can. Our customers will see no different. We're going to do what we said we're going to do. We're going to produce for the customer. We're going to produce for the shareholder, and we're going to take care of our employees.

Your next question comes from the line of Justin Long from Stevens. Please go ahead.

Thanks. Good morning, and congrats on the quarter. Thank you. I wanted to ask about incremental margins. If we go back to the investor day, you had talked about 75% incremental margins or so, but if we kind of look at the business pro forma for this year, given the cost outs that we've seen, some of which are structural, some of which are temporary, how should we be thinking about incremental margins now in a recovery scenario looking over a multi-year period?

Sure. No, it's a good question, Justin. And I'd say it depends how quick the volumes come back and where the volumes come back and how we react. So I think we're in a good spot to be able to absorb the volumes on the way up. As Keith mentioned, we've done a lot of unique things on the labor side. We have the assets in place. We've got a number of initiatives that will allow us to take on step function volumes as they come on, you know, certainly on the bulk side. As I've mentioned in the past, you know, 75% incremental margins, X depreciation, stock-based comp, and fuel surcharge, and I would stick with that today. And so all else being equal, I don't see why that would change going forward.

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

Thanks. Good morning. So, obviously, it goes without saying that the whole energy complex is under pressure, but it sounds like there's some interesting dynamics going on in the Bakken with the risk of pipeline shutdowns and capacity constraints. So, Have you had any conversations with producers or intermediaries? And do you think there's a potential opportunity to start moving crude out of the bucket again, you know, to the extent that these dynamics play out? Thank you.

Yeah, Alison, I think certainly there is. Now, as you know, the courts have stayed the shutdown of the doppel. You know, the customers, I would say, are generally pretty active in those discussions. We are moving some volumes out of the Bakken right now that we expect to continue to move through Q3 and into Q4. And I would just say the dialogue's ongoing in terms of our ability to ramp those up any greater. You know, I would also just say, you know, we don't have a lot built into our second half plan at all as it relates to frac sand either. But if there is one area that I have seen a little bit of green shoot in terms of some movements over the last few weeks is our frac sand into the into the Bakken region. So that's the both watch areas that aren't built in but certainly could present some upside.

Your next question comes from the line of David Zazula from Barclays. Please go ahead.

Hi, thanks for taking my question. Nadim, I know you touched on it a little earlier, but maybe for John, just talk a little bit about how you'd contrast the intermodal or consumer versus industrial end markets and then how that might play into either a gross dollar cap exchange, given the strength in the consumer we've seen, and or a change in the composition of how you think about capital moving forward?

Well, I'll let Nadim comment on the latter. You know, look, the consumer markets generally are fairly strong right now, as I said, with the bounce back of retail and our movement of our refrigerated products, essential goods, the reduction of the blank sailings that we've spoke to, I think we remain pretty optimistic on that recovery through Q3 and into Q4. The industrial markets, I would say across the board, are certainly a little slower to recovery, to recover. We'll see, you know, our steel and, well, and frankly, the building products actually have been pretty strong driven by the UI sort of movement that this pandemic has created. But those industrial sides, I would say, are certainly a little slower, and it's going to be a gradual recovery as we move through the year.

I would just say our capital outlook hasn't changed from what we've talked about before. If anything, we've probably pulled forward, given our capital efficiencies, some of our 22, 20, even some bit of 21 capital into 20. And so if anything, we've talked about once we get through the hopper car investment, that's a pretty significant investment for us, $600 million with 5,900 cars. And so as we finish that over the next, call it two years, you'll see our capex moderate closer to that 1.5, 1.45 billion. So it's a bit heightened as we speak today, but for good reason.

We are now out of time. I'll turn the call back over to Mr. Creel for closing remarks.

Okay, well, listen, I'll thank you for your time today. Listen, if you took anything away from this call other than the outstanding results, it should be conviction about what PSR is to this company. It's woven in our DNA. It's something we live and breathe every day. It's unique. It's a model that works, that we're dedicated to. It's producing these results. This is a team that's not afraid to set targets. We work to meet them. We exceed what we say we're going to do. You know, we pivoted to growth three years ago. We set then what we were going to do. We set then how we were going to take our unique network and create innovative solutions for our customers that drive growth, control at a low cost. It's going to drive earnings, and it's going to be sticky to this railroad. We've innovated. We've led the industry the last several years in growth, and we'll do the same this year. And we set a line of sight to fully expect and be able to do that and 21 and 22. That's what you should expect from this team. It's a unique investment story. It's a unique story within the PSR world, and we're proud of it, and we're proud that we're able to reward our shareholders that trust us to do that as we reward our employees and as we reward our customers that partner with us. It's a responsibility we take seriously, and you should fully expect that we'll continue to do that. So thank you for your time. Everyone stay healthy, and we look forward to sharing our third quarter results when the time is appropriate. Take care.

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