Canadian Pacific Kansas City Limited

Good afternoon. My name is Travis, and I will be your conference operator today. At this time, I would like to welcome everyone to CPKC's third quarter 2023 conference call. The slides accompanying today's call are available at investor.cpkcr.com. 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, please press star two. I would now like to introduce Chris DeBruin, Vice President, Capital Markets, to begin the conference. Please go ahead, sir.

Chris DeBruin Thank you, Travis. Good afternoon, everyone, and thank you for joining us today. Before we begin, I want to remind you this presentation contains forward-looking information. Actual results may differ materially. The risks, uncertainties, and other factors that could influence actual results are described on slide 2 in the press release and in the MD&A filed with Canadian and U.S. regulators. This presentation also contains non-GAAP measures outlined on slide 3. Please note, in addition to our regular quarterly financials, there is supplemental Q3 combined revenue and operating performance data available at investor.cpkcr.com, which some of today's discussion will focus on. With me here today is Keith Creel, President and Chief Executive Officer, Nadeem Villani, our Executive Vice President and Chief Financial Officer, John Brooks, our Executive Vice President and Chief Marketing Officer, and Mark Redd, our Executive Vice President and Chief Operating Officer. The formal remarks will be followed by Q&A. In the interest of time, we'd appreciate if you limit your questions to one. It is now my pleasure to introduce our President and CEO, Mr. Keith Creel.

Thanks, Chris. Let me start by thanking the CPKC family of 20,000 railroaders across our three great nations who have been hard at work providing service for our customers. The effort and passion they demonstrated each day as we integrate and execute is truly commendable. So let's take a look at the results of the quarter. The second quarter reduced revenues to $3.3 billion on volumes that were down 3% versus last year with an operating ratio of 61.7 and EPS of $0.92. So no doubt a challenging quarter as we dealt with the softer demand environment and supply chain impacts from the strike at the Port of Vancouver, but we'll let John talk more about that in a few minutes. Thank you. As you've seen in the press release, given a more challenging environment, further stressed by the labor strike, we're adjusting our 23 guidance accordingly. Certainly not the outcome we had planned, but it's the prudent thing to do at this point. That said, it's not the challenges that define us, but rather how we respond, and I'm very proud of how this team, our collective KC families, are responding to the challenges. We'll say a few things about the Mexico Task Force. That's an excellent case in point to how we respond in the Task Force. You'll recall back in our second quarter call, we talked about an enhanced focus on operations in Mexico. Shortly after that, we deployed a task force to Mexico that was led by John Orr. John, who many of you are familiar with, has a lot of experience in Mexico from his previous role as EVP officer for KCS and KCSM. And I can tell you this effort was monumental. It brought together railroaders from every part of the organization, nearly 100 employees across information services, network services, marketing, engineering, mechanical, and many others came together to support John and the task force. objectives, and we're seeing the results from that effort. You can see noticeable progress across all the operating metrics, train speed improvements, terminal dwell reduction, car miles per car day improving, locomotive productivity improving, and ultimately the most important part, the service experience for the customer. And this transformation is ongoing, and the investment in people, process, infrastructure, and technology in our Mexican operations as well as our U.S. and Canadian operations is a continual journey. On the safety front, we've continued to rise to the challenge from a safety perspective. Mark will speak to some of this in more detail in a moment. But I can tell on a combined basis we've seen year-to-date improvement in FRA personal injuries of 12%, FRA train accident frequency of 37%, which is a tremendous result that I want to commend the entire team on as we continue to lead the industry in this space. Safety is a never-ending journey, and it continues and will always be our number one priority. A few comments on the integration. On the integration front, integrating these two companies obviously is a challenge in and of itself, particularly so in today's world with an industry with a history of merger-related service challenges. We certainly have not been perfect. There are opportunities to improve that that we're mining every day 24-7. But the teams from the Legacy CP and Legacy KCS have embraced the challenge. They've united, working together to produce a unique outcome that will benefit our customers, our communities, in each other. A couple points on the MNBR. While we continue to make progress integrating these two railroads, we also continue to progress the MNBR transaction that we announced in June. Pleased to announce that we filed our application for the deal with the SDB on October the 6th. So in closing, we're a little over six months into this combination, into our forever story. There's no doubt there's a few near-term challenges from a softer demand environment. Regardless, the differentiated growth opportunities we've laid out and guided to remain unchanged. We're successfully integrating this network. We've maintained our commitments to our customers, to the regulators, and we're seeing momentum in our operating performance. So with that said, I'm going to hand it over to Mark to speak to the operations before John brings some colors in the markets and Nadine elaborates on the numbers.

Thank you, Keith, and good afternoon. I'd like to start by thanking the CPKC operating professionals for their tireless work and dedication to safety and operational excellence. The first six months of the merger has been both exciting and challenging. This team is up to the task, and they're delivering on their mandate to integrate the CP and the KCS network seamlessly while maintaining safety as CP's top priority. So if we look at safety for the quarter, I'm pleased to report that we continue to build on industry-leading records Our Q3 FRA reportable injuries improved by 35% to a 0.97. Our train accident is reported improving 9% to 1.3. As I discussed on last quarter, stakeholder engagement is a core pillar of our safety performance. We regularly engage our employees, our union leadership, our regulators to help collaborate safety best efforts, ensuring alignment. Since day one, we have held two safety walkabouts, where CPKC leadership and partners directly engage with the field employees across the property. Our safety walkabouts are key to a strong, consistent safety culture. Turning to the operating performance, I'll speak on the metrics from a comparison to CPKC with a combined combination that occurred in 2022. Locomotive productivity improved 4% versus Q3 last year. Average train speed and length declined 2% and 1% respectively, and average train weight was down 2%. As we focus and remain on our aligning operating practices across our network, we feel very good about the progress that we have made in the first six months. We're optimizing our train concept to improve locomotive productivity and fuel efficiency. To that, fuel efficiency improves to potentially Q2 to Q3, and I expect that to continue in the area for opportunity as we look forward. So if we look at where we sit today, network-wide dwell has improved 13% since the beginning of the third quarter. We have further to go, but the metrics across the board, locomotive productivity, car miles per car day, and dwell are all moving in the right direction. We feel confident that these gains are sustainable. If we look at our capital projects for the year, construction of the second span of the Laredo Bridge is 35% complete. We remain on target, operationally should be in by the end of 2024. If we look at our $275 merger capital commitment we've made, we have put in service two of the five sightings. We look for the next three sightings to be within service within three months. As we In closing, when we look at the early stages of the journey as a combined company, I'm very confident in the actions and taking the development of the network and alignment operations. This story will continue to have continuous improvement, and my team will be laser-focused on delivering strong results. With that, I'll turn it over to John.

All right. Thank you, Mark, and good afternoon, everyone. So as Keith said, we're just over a half a year in as CPKC, and I want to say that I'm as excited as ever about the unique opportunities that this franchise has to offer our customers. While it's certainly been a more challenging quarter than I expected, nothing that we've seen diminishes any of the exciting growth opportunities that we've guided to over the long term. My team has been hard at work in creating new markets, capturing new business, and I'm extremely proud of what we've accomplished today despite this challenging economic backdrop. CPKC's unique footprint and our self-help initiatives are differentiators in this marketplace, and we are extremely well positioned as the volume environment rebounds. Now, as I look to the third quarter results, on a reported basis versus CP standalone in 2022, total revenues were up 44%, while volumes were up 31%. On a combined basis, total revenue was down 4%, while volumes declined 3% versus pro forma CP Casey a year ago. FX was a 3% tailwind, while fuel was a 6% headwind on the quarter. The pricing environment remains strong with inflation plus renewals across our book of business. Now, taking a closer look at our third quarter revenue performance, I'll speak to the FX adjusted results on a comparison versus CPKZ had the combination occurred in 2022. Starting with bulk, grain revenues were up 7% on 9% RTM growth. Canadian grain volumes were up 13% year-over-year driven by the improved harvest lapping the drought-affected prior year. U.S. grain volumes were up 6% as this year's harvest has been solid in our service territory, and we are benefiting from our expanded destination market reach. We continue to see new and unique grain flows emerge on the CPKC system. Customers are taking advantage of the opportunities to connect grain origination and destination in ways never available to them in the past. Now, looking forward, projections for the current Canadian grain crop harvest has come down since our Q2 call. Our customers are now estimating the crop size to be in the 60 to 65 million metric ton range. Currently in Canada, we are seeing customer demand to start this crop year at levels below our resource planning, giving us available capacity to offset some of this headwind with shipments of U.S. grain. As a reminder, the CPKT combination has further diversified our grain franchise, and the U.S. grain markets now make up more than half of our grain revenues. On the potash front, revenues were down 22% on a 28% volume decline. Our potash volumes were impacted in the quarter by the strike at the Port of Vancouver and continued outage of Campotex Portland Terminal. To say this has been a challenging supply chain year for our export potash volumes with Campotex is a true understatement. Now, looking ahead, although we do not expect the Portland terminal to come back online before the end of the year, we do have a strong demand outlook for Q4, and we're working hard to maximize our volumes through all available terminals to build some momentum with Campitex as we close out the year. And to finish out on our bulk business, whole revenue was flat on 7% volume growth. With favorable compares in Q4 following last year's outage of Tex, Elk View Mines, and higher met coal prices as we sit here today, I see a very strong growth in coal as we finish out the rest of this year. Now, moving on to merchandise, the energy, chemicals, plastics portfolio saw a 3% decline in revenue and a 5% decline in volumes. Lower volumes were driven by a decrease in crude business as a result of a facility maintenance and less demand in LPG. However, this was partially offset by growth in our refined fuels, including new business with Shell that began in August and continues to ramp up. And plastics growth... out of Canada into the U.S. and all the way down into Mexico. Now, as we move into the fourth quarter, I expect positive RTM growth in energy, chemicals, plastics, driven by continued strength and refined fuels as Shell continues to ramp up and we onboard new share wins. For forest products, revenues declined 6% on a 4% decline in volumes. While we are seeing the impact of a softer economy and slower housing markets, we are very encouraged about the quick development of long-haul forest product shipments from Canada down to our southern markets. The combination of our seamless route to market and the development of our transload network will position us well to capture synergies in this market as it rebounds. The metals, minerals, and consumers product portfolio was up 2% on a 1% decline in volumes. Performance in this space was mixed as consumer products and frac sand were down, but metals continued to have a strong performance. We are particularly encouraged by continued growth from the Mexico steel space. Production is ramping up to support strong demand for the auto industry and for infrastructure construction projects, and CPKC's footprint in Mexico is uniquely positioned to serve as this growing market. Automotive revenues continue to be strong, up 21% on 11% volume growth, a record quarter. Demand for finished vehicles remains strong as the auto industry continues to be challenged with high finished vehicle ground counts exceeding available supply chain capacity to move these vehicles to market. We are working with many of the OEMs to create unique solutions to improve rail efficiencies that will increase capacity and help clear this inventory. I'll note that as of now, we do not expect the auto strike to materially impact our business as we are focused on servicing the strong demand from our production facilities in Canada and in Mexico. And finally, on the intermodal side, revenue was down 19% on a 10% volume decline. Domestic intermodal volumes continued to be pressured by soft market demand, higher inventories, and competitive over-the-road rates. However, we remained extremely encouraged by the uptake of our new 180-181 cross-border service. The opportunity in the cross-border intermodal space is significant. Our service is consistent and truck-like, and we are in the earliest stages of developing this premium rail market. Moving over to the international intermodal area, volumes were challenged in the quarter by the Vancouver port strike and softer demand. Although we are excited as ever about this space and we look to continue to expand our services out of the Port of St. John and to grow Lazaro Cardenas, we expect near-turned headwinds as ocean carriers continue to blank sailings and right-size their capacity in reaction to the softer demand. In closing, so certainly while we are not immune to the headwinds impacting the economy and certainly the entire rail and transportation sectors, we remain uniquely positioned to deliver long-term differentiated growth. This powerful combined franchise is creating new opportunities for our customers to grow, and our synergy gains and the opportunities ahead of us continue to exceed our expectations. So with that, I'll now pass it over to Nadim.

All right. Thanks, John, and good afternoon. I would like to first thank the entire CDKC team for its hard work, focus, and resilience. This team of railroaders is making history, and I'm very pleased with their perseverance and dedication in the face of a more challenging operating and macro environment. Looking at the quarter, CBKC's reported operating ratio was 64.9%, and the core adjusted combined operating ratio came in at 61.7%. Earnings per share was $0.84, and core adjusted combined earnings per share was $0.92. Results this quarter were impacted by the change in fuel price on both revenue and operating expenses. The impact of fuel price was a $95 million headwind to combined operating income. This includes a $72 million unfavorable lag effect on combined fuel revenue. The $95 million impact to combined operating income translated to a 70 basis point and $0.08 headwind to core adjusted combined operating ratio and EPS, respectively. Based on where fuel prices sit today, we expect the fuel price headwind from Q3 to be a slight tailwind in Q4. Now, taking a closer look at our income statement, reported operating expenses provided on slide 14 and combined operating expense on slide 15. Similar to what we shared last quarter, our combined operating expense illustrates the estimated effects of the acquisition for the third quarter as if the acquisition closed on January 1, 2022. Reported comp and benefits expense was $598 million, down 4% on an FX-adjusted basis when compared to combined comp and benefits expense a year ago. Driving the FX-adjusted decline was lower current service costs in the DB pension plan, resulting from higher discount rates and lower stock-based compensation. That decline was partially offset by wage inflation. Headcount was down slightly sequentially in Q3. We expect headcount to be down sequentially again in 4Q, which will continue to give us improved operating leverage as volumes accelerate into the end of the year. Fuel expense was down 86 million, or 21%, on an FX-adjusted basis when compared to combined fuel in Q3 2022. The decline was primarily driven by a $93 million or 16% decline in combined fuel price, along with lower GTMs versus prior year. As I mentioned a moment ago, that reduction in fuel expense due to price was more than offset by a $188 million headwind from a decline in combined fuel surcharge revenue. Combined materials expense was down 4% on an FX-adjusted basis. The decline was largely driven by reduced locomotive maintenance material spend. Equipment rents were up $24 million on a combined basis, or 34% on an FX-adjusted basis. Equipment rents increased due to higher car hire payments resulting from automotive volume growth, lower use of CPKC intermodal equipment by other roads, and increased use of pooled equipment. Combined depreciation expense was up $32 million or an FX adjusted 6% resulting from a higher asset base. Combined purchase services and other was $506 million or roughly flat year over year on an FX adjusted basis. A business interruption insurance recovery in the quarter related to 2021 flooding and wildfires in British Columbia offset increased casualty expense and cost inflation. Looking to 4Q, I still expect PS&O to come in around $530 million to close the year. Moving below the line, other components of net periodic benefit recovery decreased $17 million, reflecting higher discount rates compared to 2022, and other expense was up $6 million in the third quarter on a reported basis. Net interest expense was $207 million or $202 million on an adjusted basis. The decline was driven by a reduced debt balance. On a combined basis, income tax expense was $258 million. We now expect the CPKC core adjusted combined effective tax rate to be approximately 25% for the year, a reduction of 50 basis points from the outlook provided in Q2. Turning to slide 17, we are generating strong cash flow with cash provided by operating activities of $1,027 million in Q3. Our first call on capital remains the business growth, and in the quarter we reinvested over $700 million in line with our expectation to invest approximately $2.7 billion in combined capital in 2023. We generated $454 million in adjusted combined free cash flow on the quarter in just under $1.4 billion year-to-date. Our combined leverage is 3.6 times on our path back to our target leverage of 2.5 times. In review of the quarter, despite challenges, John's teams continue to bring on synergies, and our operations are gaining momentum, especially in Mexico. We remain well-positioned to deliver on our long-term guidance, and I am extremely confident in this team's ability to execute. I'm excited about what this franchise can deliver, and I look forward to sharing our success with you going forward. With that, Keith, let me turn things over to you.

Okay, thank you, gentlemen. Let's go and open it up to questions.

Thank you. 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 star two. As previously highlighted, please limit yourself to one question. Our first question comes from Chris Weatherby, Citi.

Hey, thanks. Good afternoon, guys. You know, I guess you just mentioned that you've been able to capture some of the synergies from the deal. So maybe... If you could help us sort of understand what you think from a synergy perspective you'll be able to realize here in 2023. And then I guess what it will take to maybe reaccelerate earnings growth back towards some of the longer term targets that you have. Is it simply just getting into a better macro environment or are there some incremental cost actions or others that you can take sort of early in 2024 to kind of reaccelerate the earnings growth profile?

Well, maybe I'll start, Chris, on the synergy piece. This is John. So, as I said, I'm really pleased. Despite the challenges we're facing, certainly in the macro and all the geopolitical things going on that we're all facing, the team has been laser-focused on the synergies. and certainly delivering on a lot of things we laid out at Investor Day. I think we said at Investor Day we saw an immediate run rate of $240 million sort of annualized. I can tell you I know we pushed that to $350 million that we talked about at some conferences, and I'm comfortable in telling you that we're beyond that now. I'm not going to peg quite a number for you at this time, but I'm quite comfortable we're going to end up north of a number like that. So I'm quite pleased. And I'll tell you, there's a number of contracts and opportunities that are ready to go, but we'll start up in 2024. That will continue to add to that story.

Chris, I'll just add a little color on the cost side. We're ahead of our target on the cost side as well. If we talk about accelerating, what I expect to see in 2024, you know, as we de-bottleneck and continue to prove upon even numbers that Mexico is