Canadian Pacific Railway Limited
Q4 2018 Earnings Call Transcript

Published: 24 Jan 2019

[Operator:]

Good afternoon. My name is Jesse, and I will be your conference operator today. At this time, I would like to welcome everyone to the Canadian Pacific’s Fourth Quarter 2018 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 speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] I would now like to introduce Maeghan Albiston, AVP, Investor Relations and Pensions to begin the conference.

[Maeghan Albiston:]

Thank you, Jesse. Good afternoon, everyone, and thank you for joining us today. Before we begin, I just want to remind everyone that this presentation will contain forward-looking information and then 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 MD&A materials that are filed with Canadian and U.S. regulators. This presentation also contains non-GAAP measures, which are outlined on slide two as well. With me here today is Keith Creel, our President and CEO; Nadeem Velani, Executive Vice President and Chief Financial Officer; and John Brooks, our Senior 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 with a follow-up if required. It’s now my pleasure to introduce Mr. Keith Creel.

[Keith Creel:]

Okay. Thanks, Maeghan and welcome to the call today. I think it’s appropriate, let me start by thanking our 13,000 strong CP family that have produced the results that this leadership team has been honored to discuss with our shareholders and with our investors today. As you can see from the release, by every financial measure, literally, every financial measure, this has been a record year, both on the quarter basis as well as a yearly basis. Specifically, for the fourth quarter, revenues, $2 billion, a CP record, up 17% versus the fourth quarter of ’17. 56.5% operating ratio, an all time quarterly record for CP. Adjusted EPS grew 41%. From an operational and safety perspective, the results were equally impressive. We had record GTMs, record RTMs on our network this quarter while we continue to drive improvements across all of our key operating metrics, train’s fees were up 3%, [indiscernible] down 6%, fuel efficiency improved 3%, which is an industry best. And most importantly, above all else, we executed safely, driving personal injury improvement by 14% and train accident improvement 31% versus the fourth quarter of 2017. So with that said, on a full year basis, 2018 was our best ever year for FR and personal injuries [ph] at CP as well as the 13th consecutive year CP has reported the lowest train accident frequency ratio in the industry. Now beyond the immediate financial strength of the fourth quarter, 2018 was also a very meaningful year across the organization from a sustainability standpoint. As I highlighted back at our Investor Day, for those who truly understand our CP story, it's a compelling one. We've got the service, the constructs of the capacity to grow in a profitable and stable way. 2018 was an absolute proofpoint of these facts and stage. The record performance in 2018 was an undeniable example of what our operating model can produce. We grew the top line to record levels by bringing on new customers, while we grew with our existing ones without compromising our ability to provide capacity and deliver the service they deserve and that we committed. The results [indiscernible] incremental cost. With these two key elements together, the natural byproduct is our best ever operating ratio and record earnings. And again from a sustainability point in 2019 and beyond, what continues to fuel my confidence in our CP story is again fact based. We’ve got a committed team of first class railroaders who know what it takes to execute the precision railroad model. This is a team that continues to get stronger, as we challenge each other in the status quo. Rest assured, this is not a team that are allowed to get comfortable and complacent. What we do and how we do, it takes the right talent. They had to be aware of the correct way, motivated and inspired to make it happen for our shareholders, customers in the North American economy. We continue to build and deepen relationships in our 13,000 strong CP family, most specifically, it was a busy and a very successful year on the labor front, not only ratifying our long term deal with the TCR running trades earlier in the year, but concluding 2018 with the ratification of a 4 year deal with Unifor in December before it expired. The change we've driven has not been easy. We certainly have not gotten it all right, but I'm pleased with the progress that we continue to make. The bill we signed provide mutually beneficial terms that will support our growth strategy, while we provide CP, its employees and our customers with the stability and the certainty we need to continue to execute and grow over the next several years. I think as a side note, it's also important to remind ourselves our next major mega contract in Canada doesn't come due until 2021, which gives us a significant meaningful quiet period to continue focus on deepening relationships even more at our company. Speaking to the guidance, we enter 2019 with tremendous momentum. Rest assured, we’re poised for another record setting year. As you review our press release, we’re targeting mid single digit RTM growth, double digit EPS growth for the third consecutive year. We did in 2017, we did in ’18 and we’re confident that again in ’19, we’ll meet or exceed those expectations. I’ve never been more confident of this team’s ability to deliver, we’re never more excited about the potential for this franchise, as we continue to write the next chapters of success in our CP story. So with that said, I'm going to hand it over to John to bring some color to the markets, before Nadeem wraps up and elaborates on the numbers and we save the balance of our time for some robust and meaningful Q&A. Over to you John.

[John Brooks:]

All right. Thank you, Keith and good afternoon, everyone. The total freight revenues were up 18% this quarter to, as Keith said, a record 2 billion with record growth across every line of business for the second straight quarter. RTM dropped 9%. Fuel and FX were tailwinds of 3% and 2% respectively and as expected, same store price continues to be strong, finishing at the upper end of our targeted 3% to 4% range. The pricing environment continues to remain healthy. As Keith stated, 2018 was a tremendous year for CP, as we executed our disciplined strategy to deliver sustainable, and profitable growth. And look, it didn't happen by accident on the backs of our industry best service, we had a plan, we picked our partners and we executed with precision in the marketplace. In October, we outlined at our Investor Day, CP’s unique strengths that enable us to offer creative solutions to our customers, including our energy train from the Alberta Heartland to Vancouver, our new and expanded transload facilities at major centers such as Vancouver, Minneapolis St. Paul and Hamilton and leveraging our land holdings to create new auto compound at Vancouver and Wolverton. We are executing our strategic playbooks, utilizing the principles of PSR and frankly the results speak for themselves. Full year total revenues are up 12% to a record 7.3 billion and at the risk of repeating myself again here, revenues were up in every line of business on a full year basis. So let's take a look at fourth quarter revenue results on the next slide. I’ll speak to the results in a currency adjusted basis. Starting off, as expected, grain was sort of a tale of two stories. Canadian grain volumes were up 7%, surpassing last year's record levels. This was partially offset by continued weakness in our US grain portfolio where volumes were down 18%, largely as a result of decreased shipments to the US P&W. Look, as we enter 2019, we expect continued strength in Canadian grain through the first half of the year, given solid crop inventories and strong regulated pricing and in the US, although January is off to a pretty decent start, we expect ongoing uncertainty in these markets. Strong export volumes from both Canpotex and K+S marked our fourth consecutive record setting quarter for potash, with revenue finishing up 24%. We had an all time record year in potash and we see opportunity, as we move into 2019, as global demand remains strong. The energy chemical plastic portfolio saw revenue growth of 46%. While certainly crude was a large contributor to ECP growth with approximately 25,000 carloads moved in the quarter, I would highlight that excluding crude, ECP revenue saw a strong growth of 26%, driven by LPG’s biofuels and refined fuels. As we head into 2019, we expect continued momentum in this line of business. Based on the strength of our service, our energy train continues to create opportunities in the marketplace. We've entered into a new multi-year agreement with Suncor, providing service from the Edmonton area to their expanding Vancouver export terminal. Also in the ECP space, we recently entered into a new multi-year agreement with a new customer to deliver refined fuels into the Southern Ontario market. This business leverages freed up capacity with the closure of our Expressway operations. As many of you will recall from our Investor Day where we spoke about this, the Expressway terminal is strategically located with direct highway access and distribution to the Greater Toronto area. So moving on, as expected, forest products were up 12% as we continue to leverage our Vancouver, Toronto and Montreal transload capabilities. The automotive business unit revenues were up 4% on the quarter, in spite of weaker demand environment in this space. At the start of 2018, this was an area that I highlighted potential headwinds for the year. So I'm pleased to report total revenues finished up 11% on the year, as our new team focused on leveraging our strong service and customer partnerships to grow our share in this market. Heading into 2019, we see growth in this sector, as we continue to attract new business to our network. Construction of our new Vancouver auto compound, which has Ford as our anchor tenant, is on track to be completed in Q1. This facility brought on by utilizing our existing strategic landholdings provides our automotive customers with a new option in the Vancouver market. So finally, on the intermodal side, revenues were up 11%. On a full year basis, I’m extremely pleased with the strong growth we've had in both domestic and international intermodal. On the domestic front, we had a record year over -- on top of a record year and I expect continued growth, as we move into 2019. In Q1, we will onboard our newest domestic intermodal customer, Dollarama to our already very strong retail book of business. Additionally, this team, I can tell you, is laser focused on continuing to leverage our demand management tools to create new valuable of capacity on our existing train starts. We are confident that this will drive more over the road conversion to our intermodal trains. On the international side, we're also projecting growth in 2019 as we leveraged our service and the capacity brought on by GCT at Deltaport to grow with both new and our existing customers at the Port of Vancouver. And I'm also pleased to announce that we have recently extended our transportation agreement with our largest intermodal customer, Hapag Lloyd. So let me wrap things up now, we, as Keith commented, we accomplished a lot in 2018 and I am extremely pleased with how this team is maturing. We're delivering results and strategically executing our playbooks in the marketplace. The demand in pricing environment, as we see it, continues to be healthy and I'm extremely encouraged by the energy and momentum we have coming into 2019 and the opportunities I see ahead. With that, I'll pass it to Nadeem.

[Nadeem Velani:]

Thanks, John. It’s an outstanding report. I'm proud to announce record results for the quarter. Total revenues were up 17% or 15% on an FX adjusted basis, driven by RTM growth of 9% in the quarter. These revenues are coming on at a high incremental margins, as evidenced by our fourth quarter operating ratio of 56.5%, an improvement of 370 basis points year-over-year. As our numbers illustrate and Keith highlighted, the railways are performing extremely well and we have strong momentum as we continue to drive productivity and grow at high incremental margins. Taking a closer look at a few items on the expense side, as usual, I’ll be speaking to the results on an exchange adjusted basis, which is shown in the right -- far right column of the slide. Comp and benefits expense was up 10% from 34 million versus last year. A few specifics behind that number, higher headcount to support increased volumes along with wage and benefit inflation were drivers behind the increase. Although a key item of note, although the share price declined during the quarter, stock based compensation was only a $2 million reduction from 2017 levels, as higher accruals were booked for long term compensation as a result of the strong performance and future outlook. Fuel expense was up 22%, primarily as a result of higher fuel prices and increased volume. This was partially offset by improvements in fuel consumption, up 3% driven by improved train utilization from higher volume. This was a record Q4 of fuel efficiency of 0.956 gallons per 1000 GTMs and record annual fuel efficiency of 0.953 gallons per 1000 GTMs. Our investment in locomotive modernization and our commitment to the principles of precision scheduled railroading were drivers behind the record numbers. Purchased services and other was $250 million, an increase of 1%. As previously highlighted, we had a land sale closed in Q4 for a gain of $35 million. However, this land sale was partially offset by a $20 million contingent claim in the quarter. Moving below the line, interest expense was $2 million lower or 6 million lower excluding FX. The reduction is primarily driven by savings from our debt refinancings in Q2 of 2018. Adjusted net income improved 38% overall, while adjusted EPS grew 41% to $4.55. To put that EPS figure in perspective, that is greater than CP’s full year EPS in 2012, prior to the transformation, just pretty incredible to think about how far we've come. Moving on to full year results on the next slide, this record fourth quarter performance rounds out a record year for CP. The plan is clearly working. For the year, revenues grew 12% and adjusted operating income grew 15% compared to the 5% revenue and 6% adjusted operating income growth in 2017. Our full year adjusted operating ratio was 61.3%, which is 110 basis point improvement over 2017, demonstrating our ability to grow volume at a low incremental cost. This led to adjusted income growth of 25%, and the benefits of a lower share count from our share repurchase program helped us achieve EPS growth of 27%. Moving on to free cash to wrap things up, 2018 cash from ops increased by 24% and free cash flow increased by 47% to nearly 1.3 billion. Shareholders are being rewarded as we remain opportunistic in our share buyback, taking advantage of all that’s sold in the equity market. We have completed around 40% of the buyback program we announced in October at prices below where we are currently trading. Additionally, a 15.5% dividend increase in May marked the third straight year the dividend was raised. Our approach to capital remains disciplined. In spite of currency headwinds and our opportunities for growth, our capital spend finished in line with expectations. As we mentioned in our press release, we plan for the same level of capital investment in 2019. When we give guidance on capital spend, rest assured, we have a well thought out and detail internal planning process. You should not expect negative surprises from us. Nowhere is that discipline more evident than in our adjusted ROIC, a record 16.2%. To put that figure in perspective, when we started this journey in 2012, our adjusted return on invested capital was just shy of 10%. Now it’s at industry best. As I told you at Investor Day in October, we're focused on generating quality returns for our shareholders, driven by our strategy of sustainable, profitable growth, while controlling costs. I’m extremely pleased with our performance, particularly in the back half of 2018 when we separated ourselves from the pack and demonstrated what a precision scheduled railroad with the best team in the industry can deliver. There's a great deal of momentum at CP and we are extremely excited to what’s ahead in 2019. And with that, I’ll pass it back over to Keith.

[Keith Creel:]

Okay. Thank you, John and thank you, Nadeem for that color. I think we’ll just save the balance of the time to open up to Q&A and robust discussion. So over to the operator.

[Operator:]

[Operator Instructions] Your first question comes from Ken Hoexter with Merrill Lynch.

[Ken Hoexter:]

Good afternoon and congrats on the phenomenal results and great turnaround. But Keith, maybe you can just delve into a little bit or John at the Analyst Day, you talked about the potential for committed contracts and in the year ahead based on things that were expiring, maybe you can talk about the progress in negotiations, as you've built into that 5.5% RTM growth into 2019.

[John Brooks:]

Well, Ken, I can tell you we're deep into those. Every one of them across those business units we spoke about at Investor Day. I can tell you it's probably too early to get into too many details on it, but I think the need thing you got to remember is part of the -- a lot of those opportunities set us up for 2021 and beyond, so a lot of that -- that revenue and that opportunity aren’t included at all, as you look at our 2019 guidance and where we expect to be. So a lot of that, I would consider, sort of a future upside.

[Keith Creel:]

But more specifically, in 2019, Ken, I’ll draw attention to what we really couldn't see back then, Loblaws closed and renewed, Canadian Tire closed and renewed, Hapag Lloyd closed and renewed, Dollarama closed and renewed, those are four pretty meaningful proofpoints of our confidence in the store, revenue store in CP.

[Ken Hoexter:]

Are those all ones that renewed or those are not new wins that you had talked about from competitive?

[Keith Creel:]

Dollarama is new. Revenue in Hapag, Canadian Tire and Loblaws, all closed and renewed, which were on the negotiating process obviously during that time.

[Ken Hoexter:]

And then just as my follow up, Keith, you kind of came out with some harsh statements in terms of what the government was looking out into the Port of Vancouver and progress, maybe, you can kind of follow up a little bit in terms of where your performance is out at the port and what you think kind of drove that investigation?

[Keith Creel:]

Okay. [indiscernible] I think I’ll try to be fact based and maybe a little bit pointed, but I think I’ll refer to the hard working employees at this company that it’s created record service levels and capacity in that whole corridor. We went through some challenges in a capacity constrained corridor at the point back in the fourth quarter, really into the beginning of January. We had to take measures to protect our overall health of our franchise, that’s a key corridor for us obviously. We have a lot of customers that are serving that corridor. We’ve got not only the carload side, the chemicals, we've got the grain, we've got the potash, we've got the coal, so it's a key corridor for CP. We’ll get to a point where we see certain business plans with equipment tied up for a number of days, waiting to get their destination in a capacity constrained location. We have a responsibility for all of our customers to take the appropriate surgical actions to make sure that we mitigate that damage and we also took immediate actions, not only to curtail some of that pressure, but to do some things ourselves to help our competitor recover quicker in that corridor, because again, we have entered into agreements, we can be the greatest competitors within that corridor, we create capacity together. So when one succeeds, both succeeds and we think that's the right thing to do, not only for our shareholders, not only for the corridor, but overall for all the businesses that goes into and comes out of Vancouver. So long answer to your question, things have recovered quite nicely, I think for both railroads. Outside, it is an episodic event. It's something that I think we responded well to and we're going to go through the process. I think the CTA factored a bit prematurely. I think that we’ll go and the facts will speak for themselves and I think it all comes out that everything that I've said, not going to be what I said, or what the facts proved to be true, CP is in good shape in that corridor, the lowest we’ve ever been, our service is better than it ever has been and it's driving a lot of these results. So again, the rhetoric will fade away, the facts will get out on the table and CP is going to bode well and in fact stand on their own.

[Operator:]

Your next question comes from Chris Wetherbee with Citigroup.

[Chris Wetherbee:]

Wanted to talk a little bit about the guidance, so mid single digit on the RTM side, presumably pricing is additive to that when you think about the top line and you've given a sort of the double digit EPS growth, which as I know a convention you've used in the past. Can you help us sort of square the circle here to a degree, maybe talk a little bit about the operating ratio, some of the moving parts there to give us a little bit of sense, sort of where in that double digit stack EPS potentially could be, seems like obviously higher than 10%, but just trying to get a sense -- a better sense about where that might shake out.

[Nadeem Velani:]

Well, Chris, I'd say that certainly we have strong confidence in the volume outlook, some of the unknowns, we'll see what happens with fuel prices, which have been pretty volatile, could be a headwind on fuel surcharge. That being said, it's a non-event from an operating income point of view for the most part. Currency, we’ve given you our guidance, which would be pretty consistent with 2018. So at a $1.30, so assuming that comes through at current levels, potentially, there is a little bit of upside, but that’s been very volatile the last 3, 4 months as well. So, we've been very positive in terms of our pricing outlook and our sense [ph] for RTM, very evidenced by Q4 results where RTM were extremely strong and that the renewal and the pricing environment that John spoke to is being very supportive. So, everything I pointed out there, perhaps with the exception of fuel surcharges could be additive to revenue growth. We’re performing well on our precision schedule railroading model and our approach toward sustainable profitable growth has helped with our incremental margins. You should expect our operating ratios to improve. We're not going to back off that approach of continually lowering that and we believe it would be a disappointment, if we weren't best in the industry in terms of the operating ratio. Certainly the back half of 2018, we were far and above the best in the industry and we plan on staying there. So all that to say, some of the negatives, in terms of the macro environment, where we are in January, depending on which headline you read, this guide can be following every now and then and it could -- we think it's prudent at this point to provide the guidance we provided of 10% or double digit EPS growth. So, do we feel confident in that number? Yes. Do we want to give you more visibility than that? I’d say not at this point. The last two years, we've been able to outperform and update our guidance accordingly. I'm not saying that that's what we'll do, but we'd rather be conservative and rather put out numbers that we're going to achieve than the other way around. So all that to say, I’m not going to give you more color than what we did in terms of our guidance.

[Chris Wetherbee:]

Okay. That’s super helpful. I appreciate the color. One quick follow up, just want to make sure I understand where CBR, crude by rail sits in the RTM outlook. Most of that I believe is take or pay, I just wanted to get a sense, are you seeing any impact on that business based on what differentials have been over the last month or so?

[John Brooks:]

Chris, we head started this 100,000 unit run rate here in fourth quarter. My expectations is, we hang around there in the Q1 and then we've got some upside as the year goes forward. I do think certainly some of the actions that have taken place here most recently in Alberta have created some, I don't know, if it's unintended consequences, potentially uncertainties in the marketplace. We've seen, I would say, some that’s slowing, some new additional business lower to come on. Overall, the volume – the base volume has held in there, but it's something obviously we're taking very seriously, we’re watching very closely and we have stayed in sort of constant dialog with the province.

[Nadeem Velani:]

And Chris, our guidance reflects conservative view on crude volumes.

[Operator:]

Your next question comes from Steve Hansen with Raymond James.

[Steve Hansen:]

Just very quickly on the labor front, how are you feeling about the employee count for the year, the traffic growth has obviously been quite strong through Q4 and even into early parts of Q1, how do you feel about the hiring front for this year and how should we think about that in our modeling process, as you think about incremental operating margins and leverage?

[Nadeem Velani:]

Yeah. I think this is still a thing of incremental productivity improvements based on mid single digit RTM growth. I think it's fair to assume low single digit increase in headcount overall. There's crystal ball.

[Steve Hansen:]

Okay. Very helpful. Thanks. And just to follow up on the crude commentary then, it sounds like some of the spread closures that have happened might mitigate some of the shorter term upside to that, but as you look into the contracted volumes through the balance of the year, should we expect the cadence to improve slightly or improve, I’m trying to get a sense for that run rate through the balance of the year, just purely what's contracted.

[John Brooks:]

Yeah. So Steve, I think, my expectation would be as we push into Q2, we make a move towards a 120,000 annual sort of run rate and then we push into the back half of the year, we will see what sort of upside that presents. I think the key here is, we’ve set ourselves up well with the right partners. There's a lot of investments that have taken place, not only at CP, but with our partners. We just want to make sure we've got a level playing field in the marketplace to sort of drive, so we can all reap the benefits of our efforts to date. And again, I'm confident that we're seeing that, but right now, I'm cautious until the whole thing is worked out between the curtailment and certainly the government interest and providing their own crude by rail service.

[Keith Creel:]

Now, I think the important part of that whole thing, the government I know that they have the best of intentions, but the reality, some of the unintended consequences, I don't truly think they understand. Put yourself in in all company’s shoes, how do they plan, how do they do contracts, how do they plan their resources, but yourself in the railroad shoes where capacity is critically important to what we do and how we maintain our business model and our service for all players in those market spaces that deserve multi capacity. If we committed capacity, committed capital, for instance, to locomotives, based on projected growth, which unintended consequence gets impeded or curtailed, as a result of these actions, I don't think that I'm just going to spend the money, don't think that if the money spend and invested in locomotives, if we have other areas of opportunity and demand by customers that we're just going to hold it in case, we've got a commitment, responsibility to those customers to maybe redeploy those assets and then you wake up 6 months from now and you say, wait a second, what happened here, railroad and locomotives, we need capacity, we need people or you're hurting the industry, you're hurting the province, well, you know what, I don't want to hurt anything yet, but I think we've got to think a little bit further out, we got to think about unintended consequences and I think there's a piece of that that’s either not understood or has not been considered that’s going to come into play.

[Operator:]

Your next question comes from Walter Spracklin with RBC.

[Walter Spracklin:]

Good afternoon, everyone. On the capacity, I want to ask a question on capacity. You had alluded or you indicated mid single digit volume growth in your guidance. If you do see higher volume growth than expected, what would you say is your current capacity, how much more could you handle and at what point do you start to see costs creep as you reach some of your upper capacity limitations?

[Keith Creel:]

I think it all depends on a lot of terms. As we've said in the past, we certainly can handle capacity, we can -- we could double it if we had to. I mean if you look at the RTM growth that we have, I mean, it's conservative. So worst case or best case, however you want to put it, we can handle double the RTM growth and not be capacity constrained, it’s not double and stacked up I guess in one quarter is all that spread out the way we manage our business. There's no one pitch point that creates huge concern.

[Walter Spracklin:]

That's great. And perhaps moving over to pricing, could you delineate between what was core? I think you said at the upper end of the 3% to 4% range. I just want to make sure I heard that right, but going forward, is there any impact on that you're seeing from truck rates coming down or anything that could lead to a price pressure, given the competitive environment that wasn't prevailing in 2018?

[John Brooks:]

Yes. So yeah, we are right at the top end of that on a same store basis. Our renewals were a little better than that in Q4. Those contracts actually pushed 4.3, 4.5 type numbers. If I look into Q1, I’d say, for the most part, we're off to a strong start with sort of similar type numbers. We’re obviously seeing close to our wholesale customers that give us a good read on the trucking markets. We’re staying close to our customers and what they're seeing in terms of their demand environment and as it stands right now, with what I believe is a long, tighter capacity, I think pricing opportunity continues. And then if we get back into the back half of 2019, and then you start to introduce ELDs and that potential mandate coming on early in 2020 and what sort of effect does that sort of bring into play, all of which I think support a continued robust pricing environment.

[Operator:]

Your next question comes from Tom Wadewitz with UBS.

[Tom Wadewitz:]

Yeah. Good afternoon and also congratulations on the really strong results. I wanted to see if you could lay out the, what you think is the likely path on the curtailments in Alberta. Is it, I mean, I guess you're implying, maybe John with your comment that the curtailment fees and you get up to 120,000 run rate. Is that the right way to view it, what are some of the puts and takes on the way things might play out, given what you know today, given what you think might change on the government actions there?

[John Brooks:]

You've put me in an area of the ultimate guess work, Tom. Guessing what between free markets and governments, the output is tough. Look, if the spread stays where it is now, at $8 and $10, I think I saw today, there's going to be ongoing pressure. I think the government has said they're going to revisit curtailment sort of on a monthly basis. February, I believe, requirement is the same as what January is. So I think right now, we expect a little bit of that ongoing pressure to continue through February. I would say for the most part, the crude shippers in our terminal though are bullish that this is going to get itself sorted out and we're going to get back to sort of the heavy demand profile that we had leading into it. In the midst of all this, we moved, I think close to 80 crude by rail trends last month and I think we're going to do similar type number here in January. So, I expect that sort of run rate to continue and then we’ll -- as we've got some additional opportunities coming on in Q2, we'll go from there.

[Tom Wadewitz:]

So, does your comment on Q2 going up to 120,000, that assumes that the spread widens out or does that happen even if you stay at $8 to $10 a barrel spread?

[John Brooks:]

Look, if this stays at 8 to 10, there is probably going to be some challenges. We’ve purposely structured the right contracts that have some backstops against the business for us, so it's not like -- there is nothing if those contracts don't start up, but our expectation right now in terms of resource planning is to have those start up as we come Q2. Now, the other thing is, those aren’t going to just all click in overnight on April 1. There is going to be a ramp up period through Q2 to build ourselves up to that run rate. The other interesting sort of, I don't know, unintended consequence is the right way to look at it, but we've actually seen a quite a bit of an uptick in activity out of the Bakken as a result and my energy team is somewhat deep into those opportunities now, assessing that potentially again we’ll take a very disciplined approach, as it relates to any sort of capital or people or a locomotive need to handle that business, but actually that could present either further upside or a backstop if some of this is delayed and coming out at Alberta.

[Operator:]

Your next question comes from Brian Ossenbeck with J.P. Morgan.

[Brian Ossenbeck:]

John, just to follow up where we left off on the Bakken. Obviously, the spreads have come down pretty significantly since October, but I know you've been pivoting some frac sand into that region to take up some the capacity you left when that crude by rail dried up, does that limit you in any way from turning that back around, putting some capacity back in the ground, if that market were to pick up as you just mentioned?

[John Brooks:]

No. I think it's an area and Keith can comment on it that we've got a pretty strong capacity in that area. You look at it, our US grain has been significantly off, right and certainly the China tariffs have limited the flow of our soybeans out of that region. So, frankly if we can backfill that with frac sand and a little bit of Bakken crude, that might actually fit our resource planning for that area quite well. And the team has done a heck of a job really honing our frac sand. Certainly, it’s an area that we see some headwinds in 2019 as in basin sand continues to fill some void out in the Permian, but we have been successful. I think, we had about 15% of our frac moving into the Bakken a year ago and we’re moving close to 50% of our frac sand into the Bakken now. So it's been a pretty successful story for us.

[Brian Ossenbeck:]

Maybe just a quick one on the margins, going back to Investor Day, we're looking at 100 basis point of improvement year-over-year through 2020. Clearly, you're looking at some good operating leverage from better volumes, excuse me, RTM growth, what is on the operating side though and productivity gains, what are some of the specifics that you're targeting there to help drive some of that improvement?

[Nadeem Velani:]

Well, certainly operating leverage is something that in this kind of volume environment, we’re describing will be supportive. We've made some very strategic investments very recently, for example, in [indiscernible] here in Calgary where we’ve spent probably $40 million, $50 million of capital in the fourth quarter of 2018 to optimize, not only that facility, but some of the blocking and some of the work up in Northern Alberta and Edmonton area that’s going to be kind of benefiting from that investment here in Calgary. So, that's going to help us allow us to improve our train speed, improve our train length and overall our ability to move through the yards much more effectively and improve our overall labor productivity as well. So, there's a number of these items that are going to be helpful. The one thing I’d point out from a headwind point of view, our guidance doesn't assume any land sales, so that's above a $40 million headwind, about 40, 50 basis point type of headwind to the OR. But yeah, we certainly expect to improve the OR, irrespective of that. So, some of the other things we talked about in terms of robotic process automation, some of the benefits from our investment in locomotive modernization, et cetera, so rest assured, we're – the pipeline of productivity opportunities are still plentiful.

[Operator:]

Your next question comes from David Vernon with Bernstein.

[David Vernon:]

Nadeem, similar kind of question, but I think at the Investor Day, you were laying out an expectation for something like a 75% incremental margin and it sounds like things worked pretty well, but you kind of fell short a little bit on what that incremental would have been. Can you talk about what maybe didn't go as well as you would have liked in the quarter and how that kind of relates to the outlook for the incremental margin guidance you gave last fall?

[Nadeem Velani:]

Well, I wouldn't say that there's something that I'd point to that didn't work out well and maybe you know, maybe, you and Maeghan can compare notes after the call, but in terms of your calculation, we certainly see in excess of 70% incremental margins within the quarter. We had some one-time negatives as well that I've pointed to in my comments, for example, we had a contingent liability and purchase services of $20 million that was accrued and there was also some higher accruals for stock based comp that was in the tune of $15 to $29. That's probably where the differences lie between our calculation and maybe where you're seeing things quickly.

[David Vernon:]

I’ve taken out the land sale as well, so?

[Nadeem Velani:]

Right. So, I think those are probably the key figures and depreciation is something that we back out as well. And so I don't think there is anything there that I would apologize for or any thesis to be made, we're very confident in our incremental margins and in excess of 70%.

[David Vernon:]

Okay. But that was excluding – so that would be excluding the depreciation tailwind?

[Nadeem Velani:]

Right.

[David Vernon:]

And then maybe just as a quick follow up, any commentary on what you're hearing from customers on the export coal outlook would be great, obviously with all the concerns about global slowdown, wondering if you're hearing anything from tech about sort of demand for metallurgical coal off the West Coast North America.

[John Brooks:]

No. Things look pretty strong. We just recently updated our projections with them, in line with what our guidance is and our expectations are for 2019. It’s an efficient pipeline and they've got a long standing strong book of existing customers and actually they see pretty, I don’t know if bullish is the right word, but expect a pretty stable 2019.

[Operator:]

Your next question comes from Matt Reustle with Goldman Sachs.

[Matt Reustle:]

Just back to the cost side, Nadeem, you mentioned land sales, are there any other cost headwinds that stop you from achieving this sub 60 OR that you've had as a run rate for the second half of the year.

[Nadeem Velani:]

Fuel surcharge is always one of those unknowns. Right. So when fuel surcharge comes on at 95%, 100% kind of OR, that can affect the math. That’s something that all of this point to. Stock based comp, we expect the stock to go up, we’ve seen it come up since year end and our expectation is go up with our plan and this stock will continue to increase over the course of the year and that will create some headwinds on comp and benefits. A couple of things I’d point out to.

[Matt Reustle:]

Okay. Understood. And then Keith, if you step back and just compare the demand environment today to where you were at the Analyst Day, are you seeing any slowdown in your end markets besides, you guys mentioned around the uncertainty around crude, but besides that, are you seeing any change in tone or shift from customers versus where we were just couple of months ago.

[Keith Creel:]

No negative. [indiscernible] So that’s the greatest degree of uncertainty. Outside of this, the macro environment does certainly have the rhetoric that’s going on about what may or may not happen in the US. But no material impact and we’re very optimistic in robust demand reports from our customers and telling them, I see consumer confidence really take a hit and consumer spending really so down. I don’t see it. Obviously, a big concern remains for us, the grand US piece, there is some uncertainty in that, but that was there in 2017 as well. We think we found the bottom. By doing those, we will see what happens to the second half of the year, but at this point, outside of this couple of things as we see underlying strength and optimism and no pessimism yet.

[Operator:]

Your next question comes from Fadi Chamoun with BMO.

[Fadi Chamoun:]

Just a couple of clarifications. So John, you mentioned the backstop in the crude by rail contract. I'm just trying to understand like the take or pay in the backstop, I'm assuming if you move -- you prefer to move the volume, but if we do end up and kind of spread remaining uneconomical, what is this backstop relative to moving the volume. Do you recover your fixed cost, do you -- like how should we think about that relative to moving 100,000 carloads a quarter -- a year.

[John Brooks:]

Yeah. You’re right, Fadi. I wouldn't characterize it as take or pay. As typical with our contract that have, what we call a minimum volume commitment, we also have a, we’ve sort of be given to get the commitment we ask them to make has a liquidated damage associated with it. So that's what we would have as part of these contracts and as we’ve certainly would always prefer to halt the traffic and earn the full revenue, but if we don't, the backstop, the liquidated damage and the liquidated damages are designed to underpin and support whatever investments we’ve made towards that particular contract.

[Fadi Chamoun:]

Okay. But there is no ways for us to kind of think about it in terms of number that the recovering half of what you would have made, moving the volume or more than that or kind of any range that you can hang on that.

[John Brooks:]

That is kind of tough and part of the issue is it varies a little bit from contract to contract, depending on the origins and the destinations and certainly the customer and the amount of other business they have relative to it. I guess my only guidance would be, be assured that if we brought on locomotive to support a contract, we’ve made sure that financially, whatever we got out of that contract, it’s not being moved with support of capital investments. I have to leave it at that.

[Fadi Chamoun:]

One other clarification, so it looked like you ramp up resources quite a bit on the back half of 2018, I think the headcount is just under 13000 kind of exiting the year. Is that kind of workforce you think is needed to handle this 5% or should we think that number goes up a little bit as well as the year goes in the context of the RTM guidance.

[Nadeem Velani:]

Sure. So, you might see a very small increase, as Keith mentioned, kind of, we're doing mid single digit RTM growth, maybe low single digit headcount growth, but one thing to keep in mind, it's usually a long lead time as you know to hire and train, et cetera. So last year, first half of the year, we're ramping up a lot of training that there's an unproductive workforce, we had some stops and starts with the labor instruction and a very difficult winter. So there was some noise in the 2018, certainly, the first half of the year. I would expect, at this point, a very small level of hiring in that 1% to 2% right now type of number, Fadi. And you won’t see the same dynamic in terms of an unproductive workforce. So all these, as you know, you've been around long enough that the attrition is always there in your back pocket to support you and attrition is always there. It's something you need to replenish, so we're always hiring, but we're not going to over hire and I think we've done a good job of being able to forecast some plans and not get caught, whether it's from a people resourcing point of view or from an asset resourcing point of view and so we feel good about the visibility we have to see the volumes and what we’re resourcing through the support set.

[Operator:]

Your next question comes from Ravi Shanker with Morgan Stanley.

[Ravi Shanker:]

The first question, can you give us a sense of what do you guys see in terms of the impact of trade and tariff headlines internationally. And any impact you’ve already seen in the international intermodal business in terms of people building up in inventory in 2018 that could potentially lead to an overhang in 2019 or any sign of nervousness that you may see a decline in ordering in 2019.

[Nadeem Velani:]

Yes, Ravi. I guess I think we did see a little bit of late Q4 surge in international volumes as a result of the tariffs. But I can tell you this, my team convinced me to take my January numbers and February number down a little bit and we haven't seen that happen at all. The volume continues to be, I would say where we expected or slightly stronger. I think the thing I'd point out is, part of this depends on the partner you pick to associate with in that space and in the operating performance, you have for that business and at the end of the day, we're secure in that area. We have no major contracts coming up for renewal, we just renewed Hapag Lloyd. They've been a very strong performer, the O&E business continues to grow with us. So we expect a tailwind to continue despite some of that rhetoric and noise and then as I look ahead and this goes back to some of the earlier questions, there is opportunities for us to growing that base, as we move along in 2019 and into 2020.

[Ravi Shanker:]

Thanks for the color. And just a follow up, thanks for the additional detail on the slides this time, if I can ask you on slide 10 where you have the pie chart on your merchandise breakdown and energy chemical is 47%. Do you have a sense of what that number was 12 months ago.

[Maeghan Albiston:]

I don't think it’s moved materially, Ravi, but I can follow up with that number after this call.

[Operator:]

Your next question comes from Allison Landry with Credit Suisse.

[Allison Landry:]

And maybe just first going back to the comment about – Nadeem, your comments a couple of questions ago in terms of right sizing the resources and Keith, I think you mentioned earlier being able to handle 2x RTM growth. Should we take this to mean in terms of there being some latent capacity in the network, if the macro does unwind maybe sooner than expected, will it take a little bit longer to rightsize resources or is that a non issue in your opinion?

[Keith Creel:]

That's a non-issue. If any of that were to happen and these opportunities were to [indiscernible] anyone else in this industry, we keep our figure on that routinely daily. It's part of the DNA. It's well within our blood and we need it on the signing process, going up and going down. That will make a case in a down market and I’m saying this firm conviction this round would be better than the other round with this industry.

[Allison Landry:]

Okay. And then as my follow up, I wanted to ask a little bit about the US regulatory environment and specifically if you have any thoughts or insights on the potential regulatory implications of PSR in the US, given the change in Congress and the Transportation Infrastructure Committee, do you think that the misunderstood notion that PSR’s cost cutting and CapEx reduction strategy along with maybe the fact that more rails are revenue adequate versus years past, does this add a layer of risk from the regulatory standpoint that maybe the industry and the market hasn't seen in a number of years and how worried are you about that and how worried should we be?

[Nadeem Velani:]

Well, I think we have to be cognizant. There's always a risk and we have to manage that. And I think you manage that by educating the regulators as well as the customers with the facts. You can look at our case in point, Allison, I mean, we started this journey of PSR in 2012. We fix the engine, it's run like a sewing machine and we're a growth engine now, we’re not a transformation engine. So we sort of go through the cycle, continue to evolve, we continue to improve, we're not perfect obviously, but at the end of the day, I think by and large, helped our customers that may have resisted the change in the onset. Those are happy customers today because we've created precious capacity that's allowing those customers that have partnered with us to win in the marketplace. You look to some of the rhetoric and some of the concern about investment in infrastructure, we've never invested more money, you look at our safety record, it's never been better. So if you want a case and prove that PSR works, if it's executed properly, there's a case study out there. That said, I know and I respect the other CEOs of these railroads and they understand some of those nuances. I see what the STB is doing. The STB is asking questions, they're trying to learn, trying to get educated and I also believe that with the prudent voice based on fact, that they think that action is necessary then they'll act, but the reality is it proves itself out that means CSX again, I don't have to advocate for CXS and results advocate for themselves, they implemented PSR, there's obviously growing pains, change is never easy for anyone, but at the end of the day, they've created capacity, created service and by and large, if you talk with their customers overall, I think they would support those statements. So again, if it's fact based and we educate and try to curtail some of the rhetoric and to speak to points of fact and points of experience, I think that's going to outweigh the rhetoric that’s out there and balance and offset the risk.

[Operator:]

Your next question comes from Seldon Clarke with Deutsche Bank.

[Seldon Clarke:]

Just in regards to your volume guidance for this year and just the different opportunities you’ve laid out for growth, how resilient do you think mid single digit volume growth is next year in a more sustained macro slowdown.

[Nadeem Velani:]

How resilient?

[Seldon Clarke:]

Yeah. I mean just like, could you give us some context around like some of the different opportunities that you see that are more insulated from, if we continue like hovering around 1% GDP growth. I'm not talking about a recession or anything like that, but just maybe what the opportunities are that are less macro sensitive versus like the typical industrial production carloads that class 1s move?

[John Brooks:]

Well, certainly, a big part of our business remains our bulk franchise and I expect for the most part, our grain business would fall in that category, although we set record -- had a record year in potash, I think all the signals remain very strong in that marketplace. As I already spoke about, I think Tech is for the most part, expecting a pretty strong 2019. So that part of the business is pretty stable and I look for growth opportunities there. We've already spoken about the crude by rail and where we expect ultimately that to go. Then you sort of layer on, we’ve got a proven track record in our domestic base, we've been growing at close to double digits. The last now 2 to 3 years in that area, we're going to layer on Dollarama, which will be now a significant new member to our strong retail profile in that book. That’s going to provide a pretty nice tailwind and I think pretty much insulate us from any downturn that could affect domestic. I spoke about international and then I still think we've got some tailwinds, certainly in the first half of the year around O&E and we expect growth with our existing customers. Really, I could go down the list and I feel pretty good, unless the sky completely falls, that we're going to be able to achieve that guidance.

[Seldon Clarke:]

And then just last one for me, do you have a target for free cash flow this year?

[Nadeem Velani:]

We should see -- we don't have some of the landfills that we achieved in 2018. So, you should see kind of marginal improvement in overall free cash. It was around 1.3 billion in 2018. You should see a modest increase in that kind of low single digits.

[Seldon Clarke:]

Okay. Even with, I guess, you have a little bit of a headwind from CapEx.

[Nadeem Velani:]

Yeah. I mean modest.

[Seldon Clarke:]

Okay. Was there any -- I guess, was the CapEx number you guide to, is it all gross and then the difference between obviously net as the land sales, is there any investments that were pushed out or are delayed or anything like that or is it just strictly the land sales that makes a difference?

[Nadeem Velani:]

It's really the land sales. Yeah.

[Operator:]

Your next question comes from Scott Group with Wolfe Research.

[Scott Group:]

So is there any way to just quantify the size of some core in the domestic intermodal contract and then I'm -- no land sales in 2019, have we sort of run our course on real estate or are we just being conservative?

[Keith Creel:]

I’ll let John speak first.

[John Brooks:]

Yeah. So the domestic intermodal opportunity with Dollarama is a $30 million to $50 million opportunity. The Suncor opportunity will phase itself in through 2019 and carries with it some development that will really serve and bear maximum fruit as we get into 2020, probably a 20 plus million dollar opportunity near term, growing doubling, as you get into the out years.

[Nadeem Velani:]

And on the land sales, Scott, sometimes, it can be very difficult to predict what, they're still lumpy and you're doing sometimes with some government and these are councils that can be difficult to move along, as we've seen in the past. So difficult to predict some of the smaller land sales, as far as the larger pieces, one key item that – one key area that we had originally highlighted is an opportunity as part of the longer term kind of divestiture, we might target to utilize for internal kind of railroad ops, that could create a good tailwind for our growth strategy going forward. So, we’ve visited that that book of business to see what makes sense today and what makes sense with our current growth strategy and profile of business. So, we still see opportunities on that front, but they're longer term. That's how categories are forecast on that.

[Scott Group:]

And then John, if I could just ask one just quick last one on crude. So at what level of volume run rate would the liquidated damages kick in, meaning 400,000 run rate and we go to 90,000 run rate, do we get liquidated damages on that 10,000 shortfall or is it, we need to see a more material drop off before liquidated damages kick in? I just wanted something like at what level they are really protected at?

[John Brooks:]

Scott, it's contract by contract. So it would be really, well, it would probably be confidentially wrong, number one, but really difficult to sort of guide you for that, other than to say again, we built these on the premise of supporting any sort of resources that the company has had to acquire to support it. So, and it’s not dependent on that, but we would be backstopped on those fronts.

[Scott Group:]

But are those contracts running above those levels today?

[Nadeem Velani:]

I mean, some of those contracts haven’t even kicked in yet, right. So that’s the difficulty in answering it as well.

[Operator:]

The last question that we have time for today comes from Bascome Majors with Susquehanna.

[Bascome Majors:]

Keith, about a month ago, you negotiated some updated employment terms in compensation with the board. Clearly, the performance of the business has been really great as of recent and looks forward to carrying into 2019. Can you just give us a little color on what led to the revisiting of employment terms and since the whole agreement wasn't filed, for any investors who are worried about how long you're going to be at CP, kind of some of the commitments that you have made to the firm and related to that agreement?

[Keith Creel:]

Yeah. I guess in simple terms, number one, the material terms of the deal relative to how long I'm committed to CP has not changed. I'm committed on my current contract through first quarter of 2022. I'm telling you right now I'm having a great time. This is something magical that we've created with this team and with this opportunity, leading this company. So I have no intention to do anything any differently and relative to my compensation, I think it is just a recognition of some shareholders’ concern as well as the market criteria out there that if we're going to be the best performer in railroad, it's probably pretty fair that myself as well as my team are compensated fairly relative to the market, so that's all of us, it’s closing the gap between what I currently make with the market in light of that, it wasn't only I or obviously I'm the only one of the five, but we took steps as well to recognize the record performance of this teams, mid-level management wise, senior level management wise across the board. This is just keep growing of the collective effort for this entire company and we're taking steps to make sure to protect the talent that is making this happen.

[Keith Creel:]

With that, I guess we're going to wrap the call up. I want to thank everyone for their time this afternoon. Certainly as you have an opportunity to digest these results, I think you'll share in our confidence, see everything tuned up and obviously reach out to Maeghan and her team, they'll be happy to provide a little more detail as they can. And with that said, have a safe and productive afternoon. We look forward to revealing what we believe will be very strong first quarter results as well when the time comes. Take care.

[Operator:]

This concludes today’s conference call. You may now disconnect.