Kansas City Southern
Q3 2018 Earnings Call Transcript

Published: 19 Oct 2018

[Operator:]

Greetings and welcome to the Kansas City Southern Third Quarter 2018 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. This presentation includes statements concerning potential future events involving the company which could materially differ from the events that actually occur. The differences could be caused by a number of factors, including those factors identified in the Risk Factors section of the company's Form 10-K for the year-ended December 31, 2017, filed with the SEC. The company is not obligated to update any forward-looking statements in this presentation to reflect future events or developments. All reconciliations to GAAP could be found on the KCS website, www.kcsouthern.com. It is now my pleasure to introduce your host, Pat Ottensmeyer, President and Chief Executive Officer for Kansas City Southern. Mr. Ottensmeyer, please go ahead.

[Patrick Ottensmeyer:]

Okay. Thank you, and good morning, everyone. Welcome to our third quarter earnings call. I'll start with just a brief comment on Slide 4, introduction of today's presenters and I think you are very familiar with most of us. I will acknowledge the addition of Mike Naatz, as of October 1, Executive Vice President and Chief Marketing Officer. Draw your attention I think most of you saw the press release on September 10 announcing the change in our lineup here with Mike coming over to the Chief Marketing Officer role and Brian Hancock moving into the job of really previously held by Mike with a rebranding of the Executive Vice President and Chief Innovation Officer, happy to talk about that in the Q&A section. For purposes of today's discussion and presentation Brian will handle all of the sales and marketing commentary on the call today since he was in that job for the entire third quarter but you will be hearing more from Mike going forward. Moving to Slide 5, just a quick recap of the results for the quarter. We had record revenues for any quarter and in the third quarter of this year with an increase of 6% over last year on 4% volume growth. Brian, will talk about some of the growth drivers in his commentary, but we saw a number of our oversize growth opportunities continue to hit full stride in the quarter and feel very good about the condition of the business in a number of those areas. Third quarter operating ratio reported of 62.0%. Adjusting for some items specifically, the flood recovery in the third quarter from Hurricane Harvey last year, which Mike Upchurch will cover in more detail, our operating ratio was 63.4%, which was an improvement of a full point over last year. Third quarter earnings per share reported of $1.70, again adjusted diluted earnings per share of $1.57 which was an increase of 16% from the prior year. Now this shouldn't be a surprise to anyone. I think most of you have done the math and have concluded that our volume guidance that we have given in the second quarter of mid-single digits is going to be hard to achieve based on our - I think the guidance we gave was 3% to 4% at the end of the second quarter. Given our results for the third quarter and the outlook for the rest of the year, we are now shifting that to low single digit year-over-year volume growth for the full-year of 2018. And I'll remind you that a couple of important drivers to our revenue guidance been brought down over the course of the year was the delay in the start up of some crude oil moves that we thought was going to start maybe as early as the first quarter of this year, which didn't materialize until much later. But it is moving and contributing to our growth from this point forward. And then the second factor was service related issues, which, Jeff will get into in some detail here that have cost us some opportunities to grow in the second and third quarter. So, if you look at this on the surface it's hard to feel bad about our performance record revenues, operating ratio improvement of 1% over the last year on an adjusted basis and earnings per share growth of 16% year-over-year but our performance this quarter did not meet our own expectations and some of the expectations that we articulated earlier in the year, we will get better. Our service issues, we're seeing improvement. Everyday we're getting a little better, the inventories and metrics are improving. And Jeff will get into that in greater detail. And I'll turn the mic over to Jeff right now. Thank you.

[Jeffrey Songer:]

Okay. Thank you, Pat. Good morning. Starting with review of operating metrics for the quarter on Slide 7, overall velocity in Dwell saw a significant impacts related to congestion in our border region. While Houston congestion eased at the start of the quarter, we were not able to work off the backlog of traffic that built in Mexico during that time which led to elevated volumes entering peak season. This residual excess inventory accompanied by substantial year-over-year growth in cross-border traffic of 13% and 20% in quarters two and three respectively, strained our operation in the region. Excessive Dwell in our Monterrey and Sanchez terminals was the most pronounced during the quarter. Expanding upon these terminals, Monterrey is a high-volume terminal with significant local daily switching demand across the large number of customers. Elevated inventories have been slow to work off due to the inherent complexity of this operation. Our long-term operating plan for this area is to move some of the switching activity for Monterrey into Sanchez, where we will be able to handle the increasing volumes more efficiently. We also experienced some growing pains this quarter associated with the new Sanchez yard switching operation, a newly expanded mechanical work at the facility. As congestion eases we should continue to gain efficiencies from our investment in Sanchez and our continued work with cross-border, customs, and international crew processes. Estimated cost due to the congestion of approximately $7 million during the quarter related primarily to increased equipment cost, labor and overtime. Turning to Slide 8. Expanding on service recovery efforts, this chart reflects our Mexico cars online trend over the past several months. As indicated in earlier comments, events earlier in the year led to significant inventories primarily in Northern Mexico. However as shown here the total number of cars online in Mexico has reduced significantly from peak levels. Network velocity has shown steady improvement over the past few weeks and Dwell has moderated from highs as we saw in the early September timeframe. Additional actions taken to restore service include adding resources to Northern Mexico. We are leasing 30 additional locomotives in the short-term and have temporarily relocated crews into the region. We have implemented some new service plans and moderate terminal and work with the largest customers to right-size some of their equipment. We continue to work constructively with our interchange partners to ensure system fluidity. While we will see pressure on performance metrics in Q4 as we continue to work down overall inventories, we believe these metrics are heading in the right direction and we expect to see more normalized levels in the next few weeks. Other comments for the quarter included an update on PTC. I'm happy to announce that all of our PTC required subdivisions are in revenue service and we are turning our focus towards interoperability. I want to recognize the entire team for their outstanding work with PTC which has had very little operational impact during the past 12 months of revenue service implementation. Additionally as mentioned last quarter, we are on pace to start receiving the first of 15 new locomotives in January. While this will provide an overall enhancement to our road fleet with more reliable, more fuel-efficient units, we continue to right-size overall fleet with a disposition of 33 low horsepower and switching units. While it has been a challenging quarter, I believe our management team recent and ongoing investments, continued process improvements, relationships with interchange partners all remain healthy and position us to capitalize on our unique franchise moving forward. I'll now turn the presentation over to Brian.

[Brian Hancock:]

Thank you, Jeff and good morning everyone. I’ll start my comments on Page 10 where you can see third quarter year-over-year revenue was up 6% on a 4% volume growth despite continued headwinds from the closure of large utility customer facility in Texas. In the third quarter, we continue to see strong growth in cross-border carloads and revenue benefiting from key areas such as refined products, automotive and cross-border intermodal. However as Jeff discussed during the quarter, we also experienced congestion in the North Mexico region of our network. They partially offset some of the expected year-over-year volume benefit from Hurricane Harvey in Q3 of 2017. During the quarter, our revenue per unit grew 2% despite mixed pressure from the loss of the long haul utility coal business and unfavorable FX impact. Core pricing came in at 3.7% benefiting from an acceleration in contract renewal rates secured during the first half of 2018 when most of our renewal activity occurs. The Chemical and Petroleum business unit grew - revenue growth of 17% was primarily driven by petroleum and plastics with both units benefiting from favorable comps due to Hurricane Harvey. Additionally petroleum revenue grew 36% driven by strength in our southbound volumes of refined products related to Mexico energy reform. In Q3 Mexican energy reform carloads and revenue grew 164% and 123% respectively and we included an update on this important and growing business segment in our appendix. Revenue from our industrial and consumer business unit was flat year-over-year. This business unit benefited from strong forest products and appliance revenues due to the tightening truck capacity and increase brown paper demand but was offset by lower metals revenue where length of haul and volumes were negatively impacted by a shift in customer sourcing trends. This segment was also negatively impacted by the previously mentioned congestion at the border. Another segment that was impacted by the congestion was our agricultural and mineral business. In this segment revenue was flat year-over-year with growth in revenue per unit offsetting volume declines. Our food products continued to be impacted by shifts and sourcing in a temporary customer plant outage. Similar to last quarter, energies revenue decline of 2% was driven by a previously announced closure of a power generation facility in Texas and by frac sand sourcing changes. These declines were partially offset by higher volume and pricing in our crude oil business driven by increased production in Canada with increased rail utilization. Intermodal revenue increased 8% with mixed performance by lanes both U.S., domestic and cross-border businesses saw solid performance as we continue to benefit from truck conversion as well as favorable comps from Q3 2017. Similar to last quarter, this growth was partially offset by a 9% year-over-year decline in Lazaro intermodal volume. As I'll discuss on Slide 12, we are seeing some early positive signs from the actions we have taken to restore our Lazaro Cardenas volumes. Revenue from our automotive business was up 8% over prior year volumes increased due to higher carryover inventory an increase in plant production, an increase in Lazaro Cardenas import volumes and favorable comps due to the 2017 Hurricane Harvey interruptions. Our business also saw a negative impact from border congestion and continued industry network congestion that resulted in equipment availability issues in North America. On Slide 11 and in support of Jeff’s comments regarding congestion at the border we wanted to provide a perspective on the increase of volume in our cross-border business. As you can see year-over-year cross-border volume increased 20% in the third quarter. Over the last few years, our mix of shipments has shifted away from our domestic coal and more towards cross-border refined products, automotive and intermodal business. We’ll continue to see these changes impact our business over the next few years. Now to Slide 12 where, we provide an outlook for the fourth quarter of 2018 for each of the business segments. As Pat mentioned our full-year volume outlook is for low single-digit year-over-year growth. Overall demand continues robust and we're working with our customers to create innovative solutions for their growing future needs. Starting with chemical and petroleum Mexico energy reform continues to be a significant focus and unique opportunity for KCS. We expect volume growth from refined products to continue at an accelerated pace for the next few years. As additional storage capacity comes online additionally we expect plastics to grow in the second half of 2018 due to increase demand. We also expect to see continuing solid growth in intermodal cross-border in US domestic lanes. As we discussed last quarter, we are closely monitoring our Lazaro Cardenas volumes and are seeing early positive trends during the peak season as additional trucking regulations are implemented in Mexico. And as our customers continue to evaluate and take advantage of the short-term volume-based pricing strategy. Significant congestion at the port of Manzanillo is also helping to bolster our Lazaro volumes. We will see solid performance in our automotive business would grow slightly ahead of most third-party estimates from Mexico production. In addition to increasing production in Mexico our growth may benefit from market share gains with some of our biggest customers. As congestion eases the new equipment and new equipment continues to come online we expect to see continued growth in our automotive business. Our industrial and consumer business unit should continue to benefit from strong demand and tight truck capacity particularly in the paper and appliance business. However, our metal segment will continue to see unfavorable impacts of shifts and sourcing strategies and trade developments. This segment will also see the largest benefits as congestion eases and a normal operating environment returns in Northern Mexico. We expect our Ag and Min volumes to be slightly up in Q4 with steady demand in both grain and food products as well as easing in the North Mexico congestion. Our energy business will be down during the fourth quarter as it continues to be impacted by the closing of the facility in Texas and as changes in frac sand sourcing continue. However, we do expect continued growth in Canadian crude with volume similar to the level that we moved in Q3 as well as a short-term opportunity in the Permian Basin crude. And with that I’ll turn the call over to our CFO, Mike Upchurch.

[Michael Upchurch:]

Thanks Brian, and good morning. I’ll start my comments on Slide 14. Third quarter of 2018 revenues were 699 million growing 6% over the third quarter of 2017. With appreciating peso negatively impacted revenue by 10 million while fuel surcharge revenues increased 25 million over the third quarter of 2017. Reported operating ratio of 62% represents a 240 basis point improvement over third quarter 2017. Included in the third quarter of 2018 reported operating ratio is a $9.4 million gain on a partial settlement of our Hurricane Harvey claim that impacted us during the third quarter of 2017. Adjusted operating ratio improved 100 basis points despite a challenging operating environment that added approximately $7 million in extra expense due to network congestion. Incremental margins excluding the insurance gain were approximately 50%. Reported EPS was $1.70 a 38% increase over third quarter of 2017. On an adjusted basis EPS was a $1.57 and increase of 16% over the third quarter of 2017. Our adjusted effective tax rate was 29% one percentage point lower than our guidance of 30. We now expect our adjusted effective tax rate to be 29% for the year 2018 and into 2019. The lower effective tax rate is primarily due to a reduction or guilty tax expense as the Treasury Department has indicated new regulations, fixing the foreign tax credit issues forthcoming in the next few weeks that will partially remediate the negative implication of the guilty tax to KCS. During the quarter we also reported a $16.6 million, our one-time tax benefit due primarily to a reduction to the provisional repatriation liability we recorded at the end of 2017, that resulted from new interpretations and treasury department regulations issued during the third quarter. They clarified the amount of repatriation tax due. As the nature of the benefit is one-time only, we recorded this as a credit in adjustment to EPS to reported EPS. A complete reconciliation of reported to adjusted EPS is on Page 24 in the appendix. Finally, average outstanding shares for the third quarter were $102.1 million, lower than the $104.7 million average outstanding shares for the third quarter a year ago. The reduction in shares outstanding is reflective of repurchasing our common stock. Additional details on our income statement are included in Slide 23 in the appendix. Moving to Slide 15, adjusted operating expenses, which excludes the $9.4 million gain we recorded in the third quarter on the partial settlement of hurricane Harvey damages increased 5%. Fuel prices increased $16 million, network congestion drove $7 million of incremental expense in the quarter. Depreciation increased $6 million primarily from PTC in servicing. Wage inflation and increased headcount contributed to $6 million of year-over-year expenses, and offsetting these increases were lower incentive compensation of $11 million and FX impacts of $7 million. Turning to Slide 16, compensation and benefits expense decreased 4 percentage points, largely the result of year-over-year declines in incentive compensation expense of $11 million. Partially offsetting that decline was wage inflation and a 1% increase in FTE, combining for a $6 million increase in comp and benefits expense. Network congestion also increased our compensation and benefits expense by approximately $2 million due to higher crude costs and overtime. Finally, FX reduced compensation expenses by $2 million. Turning to Slide 17, fuel expense, net of IFs increased 17% due to an increase in fuel prices in the U.S. by 30% and in Mexico by 13%. Foreign exchange contributed to a $3 million reduction in fuel expense. Turning to Slide 18. Equipment expenses increased $2 million or 7%. Network congestion contributed to an incremental $4 million of car hire expense in the quarter. Partially offsetting the car higher increases are continued lower equipment lease expenses of $2 million. Purchased services increased $7 million or 14%. Repairs and maintenance on equipment increased $4 million due to lower billings to other equipment owners that are generally recorded as credits. Partially offsetting that repair and maintenance billings were savings and the materials and other line item. And again, network congestion caused us to detour some traffic to other rail partners, which increased expenses by $1 million. And turning to Slide 19. We continue to believe our best use of capital is to invest in our growth opportunities. For 2018, we're now projecting capital to be on the lower end of our $530 million to $550 million guidance. This will be the third year in a row of reduced CapEx in both absolute dollars and as a percentage of revenue. While our capital budget for 2019 has not been finalized, we do currently expect to see an increase in capital due to the purchase of 50 new locomotives. Excluding the locomotive purchases, the remainder of our CapEx is expected to be flat to slightly down from 2018 levels. We also continue to evaluate investments in growth opportunities particularly in Mexico, as the refined product market continues to show very promising growth. During the quarter we repurchased 472,000 shares of our common stock, and have now completed approximately $420 million of the $800 million share repurchase program approved by our Board in August of 2017. Combined with dividends of last year, we have provided our shareholders well over a $0.5 billion in return to capital. Finally, we continue to be very comfortable with our capital structure. We now own 77% of our equipment stemming from our seven-year effort to purchase leased equipment. During this time we have purchased over $1 billion of leased equipment resulting in an approximate 250 basis point improvement in OR, and an approximate $40 million improvement in cash and net P&L benefit. We expect to enjoy an industry - we continue to enjoy and industry best weighted average interest rate of 3.96%, and have credit metrics that are better than the peer group. And with that I'll turn the call back over to Pat.

[Patrick Ottensmeyer:]

Okay. Thank you, Mike. All right, I'll close with just a few comments here and then open up for questions. First, I'd like to say our core business continues to be strong. As Brian said in his comments, demand across most of our business units is robust. Economic outlook is positive in both the U.S. and Mexico, and we are seeing and realizing some of the oversized growth opportunities that we've been talking about for the last few quarters, specifically the growth in refined products and continued growth in intermodal and automotive. Secondly, at this moment our service is not meeting our customers nor our own expectations, and our operational efficiency is not where it needs to be to handle all of the growth that we see in front of us. We will get better. Jeff, talked in his comments about the recent trends, the assets, the resources that we're putting on this problem. Mike, mentioned the 50 new locomotives that we're buying and that we will take delivery of in 2019. And I have tremendous confidence in the team, they're focused, they're working very, very hard to get us through this and get us on our feet. And we are getting better almost every day, and I think we can see with the trends - recent trends that that we are improving. Don't lose sight of the fact of Slide 11 that Brian showed. We've had really exceptional growth in cross-border volumes in revenues for the last two quarters. So, some of this congestion is a function of the growth that we're experiencing at the border. And again, I'll just reiterate, we will get this fixed and we will get better. Third, some of the so-called storm clouds that have created uncertainty and darkened our skies for the last a couple of years are dissipating. The renegotiation of NAFTA and the signing of the new U.S. MCA still have some work to do there with congressional approvals in all three countries. But based on what we have seen it looks like a good agreement, some things that need to be worked through and I'll say that most specifically the steel and aluminum tariffs that have not yet been removed and released probably is the biggest question and obstacle to the congressional approval process. But very confident that that will move forward and remove that uncertainty. Certainly the presence of an agreement with the three countries is a very good thing and we happen to think this agreement is also a good outcome. And then the transition in the Mexican election, I look back on my comments at the end of the second quarter don't really have too much more to say. We continue to be pleased by the messaging that is coming out of the new administration. We continue to engage with new government officials as we get closer to the December 1st transition date. And again, most of the messaging, most of the signals that we've gotten are positives and encouraging that we will not see any major shift in either foreign relations or economic policy in Mexico. So, we think at this point that that all looks to be significantly less of a risk and uncertainty than it that was in the past. And then finally just close with our long-term growth fundamentals remain very strong, we feel very confident, we have good visibility in some of the oversized growth areas that we've talked about refined products, plastics, intermodal and automotive and feel that those fundamentals have remained unchanged and very strong for the years ahead. And with that, I will open up the call for questions.

[Operator:]

[Operator Instructions] Our first question today comes from the line of Allison Landry with Credit Suisse.

[Allison Landry:]

So there hasn't really been too much attention on KSU from a precision railroading perspective. So I just wanted to understand is that something you're thinking about or are there may be elements that you're considering given some of the congestion you’re experiencing. Just wanted to sort of understand or maybe if you could outline to us some other reasons why it would work or conversely would not work. So would like to get thoughts on that?

[Patrick Ottensmeyer:]

Yes Allison yes absolutely there certainly are elements of the precision schedule railroading methodology that we think makes sense. A lot of these fallback to things like lean processes, trip plan compliance, more adherence to trip plans, improved asset utilization, discipline. We are working through all of those things on an ongoing basis and we think they can be helpful to getting us through the service issues and the congestion issues we’re experiencing now. We're also paying very close attention to what's going on with our interchange partner Union Pacific. Obviously they are implementing their own version of precision schedule railroading with the unified 2020 plan. The magnitude and degree of our interchange with UP is really going to dictate that we cooperate and in some cases probably follow their lead on some changes in their operating philosophy. And again we’re staying very close to that if it make sense if their elements of the plan that we think can improve our efficiency and certainly our interchange with UP. We’re going to be very open-minded to adopting and integrating those principles.

[Allison Landry:]

Okay.

[Patrick Ottensmeyer:]

I don't Jeff if you anything more to add.

[Jeffrey Songer:]

Yes, so Pat touched on a couple of those keys really if you look at the congestion now its inventory. And so you know certainly asset utilization turning those cars faster, working constructively with customers to kind of right-size fleets if you will, for me that's there is certainly an opportunity for us in that one specific area as well as the other. We are looking across the Board we have seen some good efforts over the last couple years with fuel efficiencies really focusing in on labor productivity. Volume this quarter of 4% on labor of 1% increase there is some efficiencies being gained there but I think we can certainly go farther. And we’re certainly looking and working as Pat mentioned with interchange partners to understand how that may impact us, understand how that might shift some of our own schedules and kind of lean things up to be honest.

[Allison Landry:]

And then is there anything with like the Mexico, the labor agreements in Mexico or the border crossing that would be - prevent you guys from implementing this in terms of the cross border or the Mexico business?

[Patrick Ottensmeyer:]

No, nothing unique to Mexico. We’ve talked in the past about elongated hiring times, but there is looking to just right-size and simplify our network a bit, but there's nothing inherent to Mexico that should be any different as to how we look at that in U.S.

[Allison Landry:]

And then just really quickly in terms of the cross-border volume growth in Q3. How much do you think that the car cycle times and whatnot hurt growth and it is that something we should expect you to persist in Q4?

[Brian Hancock:]

Yes Allison, this is Brian. I would say that certainly the longer cycle times did impact us during the quarter. Over the last few weeks we've been getting much better and I would tell you much of the focus that we have with Jeff's team is just making sure that we have the correct priority as we start to turn these cars specifically in refined products, grain and automotive those are the big three where car turn and utilization is extremely important. And I would say that we've been in lockstep with our customers as we gotten through this congestion, but it’s certainly critical but I think that we’re certainly starting to see the light at the end of the tunnel and we feel like that's certainly going to be a key thing for us to focus on the future.

[Patrick Ottensmeyer:]

Just a quick reminder headline growth on cross-border for volume and revenue was a little bit better given the fact that we had the hurricane in 2017.

[Operator:]

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

[Tom Wadewitz:]

So I wanted to ask you question on the capacity in the operating side it seems like you made a good investment over time to position yourself to handle growth and you've been optimistic on seeing that growth come in. But yet you seem to run into some of these issues with congestion, the system and so forth whether it said that cross-border points sure did the Northern Mexico terminal. So I just wanted to see if you could give a sense of what gives you confident in 2019 that you be able to handle some of the growth that may come on if there are things that are different - just how you would look at that - how you would - what would give you confidence that you can handle the growth that may come on in 2019?

[Jeffrey Songer:]

Yes Tom, this is Jeff. So if we look at investments in cross-border, Sanchez's is a great new facility for us it's added a lot of capacity. The slide I really again as I mentioned the indicator for me this quarter has been the volume and that slide - the graph I showed on Slide 8 eight there, I don't want to dredge back in the Hurricane Harvey, but I wanted to show kind of the trends in total inventories online and how that's grown over the past several months. And so jumping off into peak season with the impacts we've seen for good part of the year some of those in our control some of those out of control has just really led to an elevated view jumping off point if you will into peak. And then compounding that with the cross-border growth we've seen just created additional demand. And so starting off the network with Monterrey getting clean, with Sanchez getting clean we really haven't been able to do what we wanted to do in Sanchez yet which is relieve some of the pressure and some of the volumes out of Monterrey. So as this congestion gets more clean we’ll start seeing those operating shifts and our operating plan shifts to utilize new and more efficient capacities in Sanchez specifically. We have international crews thus far we’re running maybe three, four trains a day with international crews. We’ve got five crews certified by the end of November we’re targeting to have another five certified. So that will continue to add capacity there at the bridge. We've got some new higher horsepower locomotives as we mentioned coming on here starting in January. And we continue to work with our interchange partner specifically UP on efficiencies at Laredo also looking at the Matamoros gateway how we can expand and continue to utilize that for additional cross-border volume. So I’m comfortable that capacity there. As Mike mentioned, we’re still going to have a healthy CapEx for next year and we’re still focusing on these key areas to continue to add capacity with that. That coupled with some of the simplification and some of lean concepts that we’re working on.

[Patrick Ottensmeyer:]

I'll just chime in and go back and take a look at that slide that Jeff mentioned and just look at that trend from April to September. I mean this is an issue that has been building really for six months and its going to take a while to get through it. And we’re getting better every day as I mentioned and when we get through it and began to see the benefit of some of the clearing out of the yards and then some of the capacity that we've added. We've continued to add capacity at Sanchez every year very confident that we'll be able to handle the growth that we see for 2019 and beyond. The addition of the locomotives obviously will help as well.

[Tom Wadewitz:]

What about the idea that or the risk that you don't control your destiny how you run, but you are affected a lot by UP. I guess on the Monterrey yard comment local traffic you’re affected by customer action as well. So how much of fact do you think those two things kind of add the flow from UP and getting customers to change behavior. How much of the improvement is dependent on those two things?

[Patrick Ottensmeyer:]

From a customer view, I think again, I think we've learned a little bit coming out of congestion here working with our largest customers there to really try to right size some of the equipment. We probably hold a little too much equipment for some of our main customers, but working with them to right size equipment. We are also obviously partnering or working with customers as well on capacity in their own terminals. You look at the Monterrey industry in general, and it's aged, there's probably not the capacity in general around the Monterrey area for lot of customers, but we're actively right now working in partnering ship with looking at their own terminals and how we collectively add capacity to the area. So that's certainly one positive, and if I want to take a little bit of positive away from the congestion some of the learnings and takeaways and really partnering and working more closely with the customers that certainly ongoing right now. UP obviously it's a very important interchange partner for us. We continue to work constructively with them. As I say, they're working with us on international crews in their own right, helping and assisting and working jointly with customs processes at Laredo. And as I mentioned, for me the Matamoros Brownsville gateway remains important and we're only crossing four to five trains there a day. And so there's no reason that can have a similar capacity that we got at Laredo. So, I think all the above – I think it's healthy, I think the relationships and the interchange partners is all healthy, and I think it's mutually beneficial. A lot of that traffic still a greater portion of the traffic over Laredo was UP, so there is no reason they don't want to continue to partner and work with us to get better.

[Jeffrey Songer:]

I think that's really an important thing – to emphasize is that these are joint customers. So they're equally important to our interchange partner in the north as they are to us and then just circle back on the Matamoros, so that there is a little more emphasis on that. Matamoros Brownsville historically has always been, and I'll use a word that Lance Fritz actually used, a bleed valve, it's been sort of a safety valve when things get congested. We use it to reroute traffic to reduce congestion at the border. We are now engaged with UP to look at that more strategically. The problem with the bleed valve strategy is, you don't build capacity for a longer term you tend to have higher cost. It's something that comes and goes it's used on an interim basis and frequently kind of in emergency circumstances. When we look at the growth that we have coming out of the Gulf, take refined products as a great example but it could also play into grain and automotive and other things. We're going to need to completely rethink how we use that Brownsville Matamoros gateway it's going to be a longer term strategic part of the network for both of us. We need to make sure we've got the resources and the capacity. We're going to spend money over the next three or four years on what we call the F-line, which is the route between Monterrey and Matamoros to make sure that it's up to the standard and has the capacity for the growth that we see. And that longer term I think will create a lot of efficiencies for both of us in the way we handle cross border traffic.

[Patrick Ottensmeyer:]

I had mentioned one other thing, and we don't talk a lot about FXE, but there is a project ongoing with FXE constructing a bypass around Monterrey. So as well as we work with other interchange partners, we're doing the same in Mexico. That will give us the ability to reroute trains kind of out and away from like in the most congested areas of Monterrey, So, we look for that by pass to be complete toward the end of next year. So, I think all railroads are focused on, and all railroads will continue to focus on the capacity side of things as well as the process improvement side.

[Operator:]

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

[Chris Wetherbee:]

Wanted to start on the volume side and just may be get some perspective from you maybe not so much about 2018, and how you think about how the fourth quarter lays out based on the guidance we kind of can’t get there? I guess as I look out into 2019, wanted to get a sense you have the coal issues potentially being lapping – lap so is that something we should expect to continue to be a drain on 2019? And then can you maybe talk a little bit specifically about how the refined products opportunity might ramp up next year down but we have a few of these facilities now online. You have smart origination points on the Gulf Coast? I just wanted to get sense maybe like early look or maybe how things shape up for 2019?

[Brian Hancock:]

This is Brian. First off what I would say is when you think about refined products, that is certainly where a significant amount of our focus is. If you think about the facilities that are coming online, it's not that the facilities is coming online, it is the tank storage that's coming online. And so you've already seen some increases there in the San Jose Iturbide area, you'll see two additional tanks there. Then at our facility in San Luis Potosi, those will come online in the first quarter. So, we feel very comfortable that in those two particular spaces we'll have the additional storage. There was also some construction that began earlier this year in the Salinas Victoria area. Those will come on in the third quarter and that'll be storage for the Monterrey area. So again, I think overall we feel very comfortable that 2019 is going to continue to be a year where volumes will be strong and we'll continue to work. And it's important for us to work with every single one of these groups to make sure that the loading and unloading capacity is there so we can do it quickly. Again, utilization of cars is a critical piece. When you think about the other pieces of the business I would say we're going to continue to see strong shift in there. It's a very strong economy down in Mexico. So each one of our business units is finding success in their own right, but I would tell you we're going to continue to see increases and volume increases as we move forward.

[Michael Upchurch:]

Chris, this is Mike. Specific to your coal question, that has impacted our carloads and revenue by approximately three percentage points this year. And we can't wait to get to January 1, and lapse that negative comp.

[Chris Wetherbee:]

And then maybe just thinking on the cost side Mike, you mentioned the incremental margins in the third quarter which were quite good. I know there are some – probably some incentive comp dynamic kind of moving around in the third quarter a little bit. Just wanted to get a sense maybe how sustainable you feel that type of run rate is with the topline that you're sort of expecting for the fourth quarter. Are there going to be some puts and takes maybe specifically on the incentive comp that we need to think about in the fourth quarter or and is there anything else we should be looking at?

[Michael Upchurch:]

Yes, well let me go back to the current quarter first. While we did see some favorable true up on incentive comp, remember that was because we had $7 million of incremental network expenses. And we also had a fair amount of revenue and margin that ended up getting lost or deferred from the third quarter. So generally incentive comp whether it moves up or down is more than offset by incremental margin. But as we look into 4Q, I would tell you slightly higher depreciation with the PTC in servicing on the comp maybe it's a couple of million higher going into the fourth quarter. We did obviously record a credit in the third quarter to true up the first half of the year. We do expect continuation of higher fuel costs and then Jeff mentioned some leased locomotives that we're going to add to the fleet here in the fourth quarter that will add about $1 million, little over $1 million. So hopefully those are the key puts and takes.

[Operator:]

The next question is from the line of Matthew Reustle with Goldman Sachs. Please proceed with your question.

[Matthew Reustle:]

So switching gears a bit it seems like you're making some progress at Lazaro. Can you talk a little bit about whether that's tied to the pricing rebates that you were referencing on the last call. And is it still possible that we see that volume turn positive year-over-year 4Q or early next year any updated guidance around that?

[Patrick Ottensmeyer:]

Matt, I would say we're very pleased with the results for Q3. When you think about what's happening in Lazaro, there's a couple of dynamics. Certainly, our pricing kind of led that off. I think people – there were some of the smaller carriers that took immediate beneficiary of that. But what I would tell you as well as we’re also seeing a lot of congestion at the port of Manzanillo, which is just north of our port. And some of that trade is now being diverted down into Lazaro. So, I think that – the fourth quarter, we're prepared to handle what we believe will be a very good quarter. Whether we're able to get all of the volume that we would like to get, I think it's still to be played out, but I think there's a couple of those big pieces. We have seen better fluidity there, certainly the congestion in Manzanillo, the pricing makes it able for customers to come back. And I think what's happening at least from our perspective is people are looking at the ports in a more balanced fashion. They're not playing each other against one another because they realized that all of the ports need to have capacity and fluidity. And I think that we're seeing the benefit of that. So, we expect 2019 to be certainly a year where people take advantage of that. And so I feel pretty comfortable that we took the right steps. We did it, certainly are timing couldn't have been better and hopefully we'll see the benefit of that in Q4 and Q1 as well as into next year.

[Matthew Reustle:]

And then just in terms of some of the initiatives you're talking about working with your customers on improving capacity inventory; have you considered or are you implementing stricter enforcement on demurrage detention, any thoughts around that?

[Patrick Ottensmeyer:]

We certainly kind of can see what's going on in the other railroads around those areas. For me there are certain tools we have. First and foremost, working with customers to understand the overall benefits, and while an individual customer may desire to have more cars online for their comfort. Understanding and clarifying that, that has total system and network impacts and that could in theory hurt them. So demurrage is one tool for sure, we have an active demurrage program. We utilize that effectively and I think we will continue to use the tools that we have to make sure we're incenting and really educating customers around what the right level of equipment. How we get there? For me it's more joint efforts, it's more understanding and clarification. However, we have other tools that are in our toolbox.

[Jeffrey Songer:]

Probably a good example of other things that we're thinking about to create the kind of efficiency, fluidity, the investment that we're making in refined products terminals in Mexico, the story behind that those refined products tend to be loaded in unit train quantities in the U.S. refineries. And there just isn't capacity in Mexico for unit train unloading. So, we can congest our yards and we can handle this kind of lopsided out of balance supply chain where you load units on one side and you unload small quantities on the other side. Congest our yard and argue about demurrage or we can actually use our financial wherewithal, work with our customers to create capacity to create more of a balance supply chain where we load units and we unload units. We have the same phenomenon in some of our grain locations. We have the same phenomenon in some of our steel locations. So, yeah, the demurrage I think is a useful tool to make sure that we and our customers are following the kind of discipline that we need. But I think using our capital to – and working with our customers is not always going to be our capital. But working with our customers to create more capacity away from our yards or think differently about how we handle some of the flows of these products, I think is a good long-term solution and is going to produce the kind of benefits in terms of cycle time, improve cycle time, improve asset utilization, reduce congestion that we want to achieve longer-term.

[Brian Hancock:]

Certainly the only other thing I would add is if you look at just the Monterrey area, the capacity that's been created at our customer's facility; brand-new automotive facility in the past in Mexico that wouldn't have the capacity to handle hardly anything from a storage perspective. Now with our help those facilities are significantly larger and it allows us to be able to drop a train, pick a train, be able to do things that we couldn't do otherwise. The largest soybean facility in North America is now in Monterrey. In the past that facility would not have the capacity that it has, but again with our help and design - we're helping design these facilities. It's now the ability they can store a couple of trains and that creates fluidity on the mainline. So I think what Pat said, what Jeff said, this is something that didn't exist in Mexico this mindset of creating capacity and logistics capacity at facilities really hasn't existed. And now you see these owners of the new buildings they're making those investments we're helping them do that in the correct way and I think we're going to see long-term benefits from that.

[Operator:]

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

[Bascome Majors:]

Mike, I was hoping I could unpack some of your comments on the capital budget for 2019 little bit. I believe you said kind of core CapEx flat to maybe even slightly down. The 50 locomotives, I believe you also said that you're selling 33, so there will be a bit of an offset there. Can you help us size up just incremental CapEx from that? A wide range is fine just trying to think about what that might look like?

[Michael Upchurch:]

Yes, well let's take the mystery out the locomotive purchase will be about $140 million. The units that we're going to sell are 70 vintage, super sevens. I wish we could get the kind of price we pay for a new one, but that's going to be a pretty low number. So our net CapEx from locomotives is going to go up substantially. We haven't bought any locomotives since 2015.

[Bascome Majors:]

And you kind of left a caveat in there about the project CapEx, is it that we plan to spin on some of these destination terminal projects and we just don't know what that number is or I mean if there's any kind of ballpark as to what that might look like if it comes true realizing that that's a good new story if it happens?

[Michael Upchurch:]

Yes Bascome, I would tell you at this point we don't have any agreement with anybody else that would cause us to jump into a venture to build out new facilities, but we are having ongoing discussions with a number of different partners. We're kind of looking at those facilities as let's get them on our railroad and get the opportunity to get the line haul revenue there. But it's difficult sitting here today to know exactly whether or not we'll spend any incremental cash flow on those terminals down in Mexico.

[Bascome Majors:]

Understood. And maybe kind of timing altogether I mean if you look it feels like this year that kind of in couple quarters of ratcheting down expectations is weighed on your multiple. As we look to next year, it looks like street revenues are something like high single-digit growth, low double-digit growth and the EBIT mid-teens and EPS, kind of 53% incremental margin. Is that something that gives you pause from where you sit today or if things go well is that something you think the KSU franchise can achieve?

[Michael Upchurch:]

I think that's a backward way of asking for guidance for 2019. We'll talk about 2019 more at the end of the fourth quarter. We're in our budgeting process and working through where the right assumptions in terms of network recovery, service recovery. So we'll have more to say about that in January.

[Operator:]

Our next question is from Amit Mehrotra with Deutsche Bank.

[Amit Mehrotra:]

I'm going to take another stab at that 2019 question. So as we move from I guess 2018 to the 2019, CapEx is going up maybe set by some of that service and congestion issues that hopefully abate - would likely abate. You have a long-term kind of 50% incremental margin, EBIT margin target out there that you've talked about before. I mean, it seems like with crude carload's doing what they're doing, refined product carloads hopefully accelerating, lapsing of the headwind from coal; if you don't achieve it over 50% incremental margins in 2019 I mean maybe you have to reassess the long-term target. Is that a fair way of articulating it or am I missing some of the moving parts?

[Michael Upchurch:]

Amit, this is Mike. I think that is a fair way to look at it. The first half of this year we really didn't have any volume growth and it's really difficult to generate 50% incremental margins in that kind of environment. You saw us do it here in the third quarter and rolling into 2019 with negative comp dropping off on coal. We would certainly expect nice volume and revenue growth. I'm not going to comment on specific numbers, but our target will not be any different than it is today to generate 50% incremental margins in that kind of an environment.

[Amit Mehrotra:]

And just on the energy side of the house, the crude growth was obviously very strong maybe staggeringly strong you could say. And I guess that makes sense as given the crude coming out of Canada and you're now with the Synovus volumes coming online maybe over the next six months or so and CP obviously getting a fair chunk of that. Can you just talk about what the runway is in terms of crude carload growth and just how well the Company is capacitized I guess to handle that growth next year?

[Brian Hancock:]

Amit this is Brian. Yes, we feel very good about what's going on with crude by rail. Certainly, we're working closely with our interchange partners and we feel very comfortable that we have the capacity necessary to do everything that we see in the future, everything that everyone else has spoken about that's going to hit our line. We feel very comfortable about it. It's a good business for us, we're certainly going to continue to see it grow looks like here over the next year, year-and-half. And so we're very comfortable, we can handle it.

[Patrick Ottensmeyer:]

And just remember that none of that business goes cross-border or around the sort of Beaumont to Houston to Laredo route. So, to the extent that capacity has been freed up because of the reduction in our coal business, this is a really good fit for that part of our network.

[Jeffrey Songer:]

And the spreads are extremely wide right now, WCS to mine and crude. So it should certainly give us an opportunity, but there are other railroads that operate in that region as well.

[Operator:]

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

[Ken Hoexter:]

Pat, maybe just – I don't know if it is Pat or Jeff, but your insight into the congestion, I had a lot of questions on congestion already but how do you get ahead of that? Jeff you mentioned you want to turn the cars faster, the cars online, not just the Mexico number you put up there but cars online overall at all time highs and Dwell remains high. You're adding locomotives but I just want to understand how we learn that adding assets isn't really the long time answer, and I guess going back to Allison's question on. Do you need to overhaul the network and how you're operating it to try to get more efficient, is there something that significantly needs to change so we don't keep coming up with these congestion issues every couple quarters? Just to understand how you view operations in terms of what's going on and the congestion in cars online kind of continually being a sticking point?

[Jeffrey Songer:]

Yes, this is Jeff. Do we need to do anything macro level to the system? No. Targeting these areas of congestion, Monterrey has been in the past and is right now kind of a source of congestion. But as I mentioned the investment in Sanchez to relieve that we got lot of additional capacity we've add there. So our ability to kind of make the operational changes that we've envisioned as we move on here into Q4 and next year should provide some of the benefit we've been anticipating. This year last couple of quarter signaled the importance of the rail network and as we talk about our interchange and congestion that’s moved from Texas to now Mexico. And I see inventories, take Sanchez for example we've cut those inventories in about half since the peak now. So, I feel much better that as inventory in cars to specific terminals move out that we can regain our normal operation and flow traffic between those terminals, flow traffic from the north now to the south because we have receiving capacity, for example, at Sanchez.

[Ken Hoexter:]

Mike, when you're talking inventories, you're talking cars trapped in your yards or?

[Michael Upchurch:]

Cars yes, cars overall cars online and now if you look at our total cars online, there are couple of drivers for that. One is just cycle times, the cars needing to move faster. And overall car volumes are still elevated in the U.S. trying to get south now. So this smoothing of the network is what we have to have happened. But again, the resiliency of the rail network and creating and eliminating congestion and not just moving this congestion back and forth across the bridge, it's dependent on the resiliency of the entire kind of U.S. and Mexico network. So, those are the things we’re working out, those are the things that kind of led to some of the elevated inventories we saw going into this congestion.

[Jeffrey Songer:]

But I'd also go back to what we said earlier Ken, and that is things like looking – working with UP, working on developing a longer term strategic role for Brownsville Matamoros, resourcing that gateway properly to be able to play more of – more of a strategic role for both of us as opposed to go back to the phrase bleed valve that I think is an important part of that. And then particularly at the border recognizing that more than half of our traffic at the border is interchanged with UP, just working very, very closely with them as they work through their own operational changes and making sure that we're in sync with those. The level of communication at all levels including the CEO level with UP as we work through this is very high. It has to be. And because most of the traffic we interchange at the border is going to and from them. Adding assets, adding capacity at Sanchez, we talked about adding capacity, we're not going to talk specifically but I'll go back and reinforce adding capacity at customer sites to handle some of the traffic that has historically congested our yards and improve cycle times for certain customers is a big contributing factor as well.

[Michael Upchurch:]

I had one more example. We look at our refined products terminals, as Brian mentioned with where we're at today, which will certainly improve when tanks are up and running next year, if you look at cars online, private car tanks for it one example, because we're still running some of that in manifest because they're still kind of trans-loading those cars are remaining on our network for an elongated period of time. It may take us two weeks to unload a unit train in the Salinas terminal right now, whereas we get into next year the tanks are there, additional capacity is provided. Those cars are going to turn a lot more rapidly. So I think I can't just look across the entire segment without kind of separating his issues or his additional elevated volumes because of 10 cars or car hoppers for some of the similar issues that – as capacity and some of these additional investments will continue to help out with.

[Ken Hoexter:]

Glad to hear here some sense of urgency. I mean look forward to the solution, it just seems like that's what's going to help with your rapid growth and still seems like a lot of pinch points holding cars online at those high levels. But I guess if I could the follow-up, it was just a question on crude. I just want to understand your view Pat on crude. We heard from the carriers up north, they're hesitant in taking too much crude and really limiting it given not only their fear of over doing the available capacity, but really ensuring they're getting return because knowing that it's going to disappear in three years. So in three years or so, if you're going to have another one of like what's going on in coal where it massively just disappears, just want to understand how do you view crude by rail in terms of how much you want to take on given some of the capacity constraints you're talking about?

[Patrick Ottensmeyer:]

Very much in sync with what I heard from the CP yesterday. I listened to their call and we're approaching it very similar in terms of the way we're thinking about commercial arrangements to make sure that we don't suffer from kind of extreme volatility in that business and resource ourselves to the point where it doesn't sync up with the commitments that we have from customers.

[Operator:]

Our next question comes from the line of Scott Group with Wolfe Research. Please proceed with your question.

[Scott Group:]

So, I know it's been a few years since you've given us this to us, but last time you reported it the OR in the U.S. was right around the 70, Can you maybe tell us directionally where we are today in mid-60s, high-60s, 70? And then even if you don't want to talk specifically about OR where we stand today; do you think there's any sort of structural reason why it shouldn't be sort of just as good as everybody else and if that's the case, is that something that you're focused on shrinking that gap?

[Patrick Ottensmeyer:]

I'll take the last question, absolutely. Are we focused on shrinking the gap? Yes. And do we think we can continue to show improvement in operating ratio? Yes, absolutely. We're spending a lot of time looking at, we compare ourselves to our peers. We look at dozens if not more in the cost and performance categories on a regular basis. We look at how are we performing versus the peers versus the best in class versus the industry, what the dollar value of that gap, is there any kind of structural or other reason that we can't be best in class, in some cases we are. Is there any reason we can't be average probably hard to accept why we can't be average. And then looking at what's the dollar value of closing those gaps, what are the initiatives that are responsible to close those gaps who is accountable for it and what's an appropriate timeframe to think about it. So we have that methodology where we look at ourselves and compare ourselves to peers and try to develop that framework of gaps, targets, initiatives, timeframes and accountabilities to close those gaps. And I'm very confident that we can continue to show improved operating ratio performance kind of following that disciplined and focused methodology.

[Scott Group:]

And just so we in trying to understand the opportunity, can you talk directionally where we are today in the U.S.?

[Patrick Ottensmeyer:]

No, we don't report those separately, Scott. As you know the only requirement that had us reporting that separately was subsidiary debt that we had down in KCSM level and when we moved that up to the consolidated level we basically were relieved of that obligation. I mean, we look at this as one big long network with an interchange point at the border. We remain just as one business.

[Scott Group:]

And then can you just help me think about sort of fourth quarter moving parts theory and typically your earnings are flat to maybe down a little bit, there's moving parts with incentive comp maybe some of the service cost going away, anything to just help us sort of calibrate models would be helpful Mike?

[Michael Upchurch:]

Yes, I think in response to Chris's question I gave a little bit of guidance on the expense side up a bit in depreciation with PTC, a little bit of an increase in comp. We would expect fuel prices to continue to go up. Jeff, talked about the locomotive leases adding a little over $1 million. Typically fourth quarter revenue top line is lower than third quarter. Third quarter is typically the best quarter. You get a lot of manufacturing facilities that shutdown in mid-December. Given that we were shy of where we had expected in the third quarter maybe that makes the comp going sequentially a little bit easier, but generally you're down, maybe this year will be somewhere in the flat range on revenue.

[Operator:]

Our next question is coming from the line of Justin Long with Stephens. Please proceed with your question.

[Justin Long:]

Wanted to start with a question on peak season, I'm curious what you've seen in your network in terms of the pull forward of freight ahead of tariffs. And if you strip out any impact from a pull forward, have you seen anything in the underlying demand environment that gives you pause related to inbound volumes at the ports particularly from China or are you still expecting this to be a pretty robust and strong peak season?

[Brian Hancock:]

Hi, Justin, this is Brian. Yeah, we are very pleased with the way that the peak season has come in here in the third quarter at the beginning of the fourth quarter. I would tell you we saw a little bit of a pull up in our intermodal business and specifically in the steel area there before the tariffs. And that was more of the July/August timeframe, so already in the number. We feel very comfortable that it's going to continue. All signs from our customers are that there is significant growth in each one of the key areas that would drive that. We never - if you look back at 2018, in the first quarter, we thought that our intermodal volumes would drop off, they did not. And so everything that we're seeing and hearing is that the trucking shortage will continue. So, we feel comfortable there. We will be ahead of where most of the forecasts are on automotive. We are, like Mike said, we are happy to lap our coal shutdown. So we're ready for that. I would say overall we feel very comfortable going into next year that our peak season this year has been robust and strong and most of our customers are planning to have a great 2019 as well. So, we feel good.

[Justin Long:]

And secondly I was wondering if you could provide an update on Sasol? Any change to your expectation on when those shipments start up and how long it could take for that facility to ramp up, and then anything you could give us on the contribution in 2019 would be helpful as well? Thank you.

[Patrick Ottensmeyer:]

Sasol obviously we will always point you towards their website and their communications on that as to when they will ramp up. We feel very comfortable with the way that we planned it and in accordance with them we've got our plans into 2019. I think they've said that they will start to plan up here or they'll continue to ramp up in the fourth quarter. It will be a slow ramp in 2019, but we feel very comfortable that the businesses that we support will be up and running and we'll start to see those volumes, we already start to see some of those volumes here in the late fourth quarter. But also I think you'll continue to see that ramp up into 2019. Plastics is going to continue to be a slow roll across all of the railroads I think, as you see ports and different ports and different flows then there have used to been with regard to the resins. But we're going to continuously strengthen that for the next few years as all of these plants come online.

[Operator:]

Our next question is coming from the line of Brian Ossenbeck with JPMorgan. Please proceed with your question.

[Brian Ossenbeck:]

So, two just kind of follow-up questions. We look at the frac sand volumes coming down significantly. Brian, can you give us bit of your exposure in basin if there's any way to pivot that into other areas as the in-basin sand starts to take more share?

[Brian Hancock:]

Brian, that's certainly come down significantly faster than we thought it would. The white sand out of the Great Lakes area has just - has really slowed down. In-basin the brown sand has continued to be used more and more. We believe that that will continue where it will actually level out. We're not exactly sure, but we're pretty sure that the white sand is going to continue to slowdown. And so from an exposure perspective it will really depend on where we see the balancing between the two. But I would expect to see brown sand continue to be utilized more in that Texas region and the white sand will probably drop off as it continues.

[Brian Ossenbeck:]

And then just going back to refined products, the F/X tax income administration has at least forward some commentary about possibly changing that to keep the inflation rate more in line with overall inflation. So just want to get your thoughts on that if you heard anything similar what the producers and shippers are telling you on that and how it will affect your, I guess the market and specific credit that you have from that mechanism?

[Patrick Ottensmeyer:]

Brian, I'll start that and then kind of tag teams this with Mike. I would say from a refined products perspective, the new administration has been extremely engaged in this area. They are concerned about stores, they are concerned about refining capacity and we've been engaged with them in understanding how we can support better utilization of their current refineries, helping them in developing storage. How they price that in the market and how they look at that, I think that they're going through a learning process right now on how that all goes from a world pricing prospectus. And we're going to let them sort through that, but we feel very comfortable that they are engaged and continuing with Mexico energy reform. They realized to keep their economy growing they've got to have additional stores, they've got to have additional sources. And quite frankly the Gulf Coast and the refineries there are just perfect spots to feed that volume. So, we're going to continue to see significant volume growth. So, from a pricing out maybe let Mike take that one.

[Michael Upchurch:]

Well, Brian, if you're asking what's the impact of potentially moving up or down on IEPS to our fuel expense. I think it's pretty clear that the current administration has used the opportunity to lower IEPS to try to manage the increase in fuel costs in Mexico. It's hard to say exactly what the new administration might do when they take office later this year, but I guess I continue to view IEPS as lowers the credit may be a little bit lower for us but it will also be saving that in the purchase of fuel, we won't have to pay that. So should essentially be a net wash to us.

[Operator:]

Our next question is from the line of Brandon Oglenski with Barclays. Please proceed with your question.

[Unidentified Analyst:]

This is Nat, on for Brandon. Just looking at your automotive business looking out we see in your investor presentation that production is up. We've seen some estimates that put it maybe more in the flat to even down range. Just broadly do you think you'll be able to outgrow the market from here and what gives you confidence in the outlook for the automotive business?

[Patrick Ottensmeyer:]

Yes, I would say that our automotive business continues to be strong. We had several opportunities this year to pick up share, and which we did. So, will we outgrow the market? I don't know that. I mean, production is going to continue to grow as forecast. Our expectations are and I think that 2018 has been in line with that that we will exceed the production increases that are planned. We do believe we're picking up share at some of the key facilities but we also believe that we've created some unique service offerings for some of our largest customers that have allowed us to pick up that share and so we're continuing to look at how do we create unique opportunities, unique service offerings that allow them to meet their goals at the same time get better utilization across the railroad. So, I think we'll continue to see strength in our automotive business.

[Michael Upchurch:]

Matt, this is Mike. Just about share, if you look at the third quarter results we were up in the auto segment and our competitor in Mexico was actually down. I think that's been true most of the year. So I think the takeaway there is we're probably are taking some share.

[Unidentified Analyst:]

And then just following-up, could you clarify a little on your comment around flat revenue in the fourth quarter sequentially?

[Patrick Ottensmeyer:]

Well, don't read too much into that. I just - my comment was generally speaking from the seasonal standpoint you would expect fourth quarter revenue to be lower than third quarter revenue. This year obviously our third quarter revenue could have been a lot higher had we operated the network efficiently. But going into the fourth quarter I kind of look at it may be as flat revenues from 3Q to 4Q, maybe we're a little bit above that. We'll just have to see.

[Operator:]

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

[Jason Seidl:]

I want to touch base a little bit on some of your commentaries about the lack of logistics investment historically in Mexico and given that we're sitting here on the precipice of NAFTA 2.0, how should we look at foreign direct investment and what are the long term implications for the growth down there for you guys?

[Brian Hancock:]

Jason, this is Brian. I made that comment and so what I would tell you is I think that that companies are becoming smarter in understanding that logistics infrastructure is essential when you build a facility. You can look at the two major auto facilities that were created this year, both of those a big part of the construction has been what is the logistics infrastructure necessary to support this facility. And so you think about storage, and it's not just rail, you have trucking storage, you have rail storage. And what I would tell you is, most of that design work was not done. If you think about the manufacturing facilities that were built in the '80s and '90s in the Mexico right after the North American free trade agreement was put in, I would say that logistics was not the primary concern. I believe now those companies now look at those investments certainly in the steel industry, automotive, grain, as Pat mentioned, they're looking for how do I get better utilization of my assets. They realize that once the asset is in, the largest cost they have is infrastructure from a logistics perspective or logistics expense. And so they're putting in additional track, they're putting in - you see people putting in loop track, you see them putting in a large storage yards for trucking. And so what I would say is, Mexico is developing, they're evolving. And when you think about logistics infrastructure, we're just a big part of that, a big facilitator of certainly the rail infrastructure but also helping these big manufacturers and these big CPG companies if you will, create infrastructure that allows them to be more efficient at their plants and not just to manufacturing a low cost manufacturing hub but a real fulfillment mindset inside of these facilities. And it takes time, but I would say at least the two or three big facilities that have been built over the last two years, every single one of them has incredible rail and truck infrastructure that just wouldn't have been present just 10 years ago.

[Jason Seidl:]

That's great color, Brian. So this is more of a mind and not necessarily a NAFTA thing, but NAFTA is probably not going to hurt it.

[Jeffrey Songer:]

No. But I think the other thing is, and Brian hit on this. If you think about new auto plants, those facilities are being built right out of the gate with adequate - [KIA], the new facilities that we worked, they're doing that right at the very beginning. Where we see room for improvement and room to possibly invest or co-invest with some of our customers to create better logistic efficiencies are in some of the older facilities like grain and steel that weren't built initially with that logistics and storage capacity. So, that's been a source of congestion in our yards, it's been a source of delays in cycle times or extended cycle times. So, we're trying to go into some of those older facilities and fix them so that we have more of a balance. Grains, probably a great example. Most of our grain facilities are unit shuttle loaders, so we can load 110 or 120 car train very efficiently, then we take them down into Mexico and they're broken up into 25 car blocks with congestion in our yards and congestion in mainline and all that kind of thing. So, we're trying to fix those facilities so that we can create those efficiencies or some of the older facilities that we serve. Your question about NAFTA and U.S. MCA, NAFTA is gone, remember? And then direct foreign investment, the thing is interesting over the last couple of quarters in spite of the uncertainty of the trade agreement, direct foreign investment has continue to be pretty strong. We think the removal of this cloud of uncertainty, remember we got to get it through congress in all three countries yet. But the removal of that uncertainty we certainly see as being positive for foreign investment in Mexico going forward.

[Operator:]

The next question comes from the line of Tyler Brown with Raymond James.

[Tyler Brown:]

Can you update us on your cash tax paying status post the tax reform? I think the guilty provisions and basically the NOLs, so I think you paid maybe like $50 million in cash taxes last year, just curious what you think you'll pay this year kind of how that trends over the next couple and basically when do you think you'll be a full cash taxpayer?

[Jeffrey Songer:]

Yes, we're going to trend up being a cash taxpayer. We have been paying cash taxes in Mexico for a while. We'll pay some in the U.S. but I would probably guide you somewhere in the low 20s to 24%, 25% range.

[Tyler Brown:]

And then, I'm not sure if this is for Pat or Mike, but I hate to be picky here but what exactly is going on at the PCRC? I mean, it looks like it lost money this quarter versus maybe something like a $20 million below the line annual benefit at its peak. So basically what's going on there? Is this the canal having some structural impairment of that business or am I reading into it too much?

[Michael Upchurch:]

No, I think they just had some difficulties with couple of customers, loss of some business. It's - I think we'll get through it and should start to see reversal of some of those trends in the future.

[Patrick Ottensmeyer:]

Tyler, just to be clear, it's not just PCRC that's in those numbers venture down in San Luis Potosí, TSCM, it's included in that. The terminal operator in Mexico City FTVM, that we have a 25% ownership. Interest in is also included there. So it's not just PCRC, but yes, their business is definitely down.

[Operator:]

Our next question comes from the line of Mike Baudendistel with Stifel. Please proceed with your question.

[Mike Baudendistel:]

Just wanted to ask you, I mean, EUP received a letter from STB regarding potential service concerns from changing operations with precision scheduled railroading. History tells us that could lead to some service issues at least near term getting worse before getting better. Do you share those concerns and is there anything you can do to ensure that they remain effective interchange partner?

[Patrick Ottensmeyer:]

Yes, I mean we're staying on our toes. We think EUP, what they have said publicly, what they've told us is they're going to go about this perhaps in a different way than some of their peers. But all I can say is we're on our toes, we're staying very close to them so that we anticipate and we can prepare and plan for any changes in behavior that we've come to expect that we've seen in the past as they make their transition to a different model. Communication level is very, very high as I said earlier at all levels with EUP right now.

[Mike Baudendistel:]

And then just wanted to ask you, I think you said core pricing came in at 3.7%, I mean is there a forward looking metric there that you can provide of renewals?

[Michael Upchurch:]

No, I would tell you that the 3.7% is a good metric. We feel very comfortable in the pricing and this is a great pricing environment, right. So we're going to continue to see strong pricing opportunities both in Mexico and U.S. and we're going to take advantage of that where we can and we feel very comfortable especially in the mix that we see happening, the changes that we're going be very positive in the pricing space. So, we feel pretty comfortable that we'll stay very close to this type of pricing here into the near future.

[Operator:]

Thank you. There are no further questions at this time. Mr. Ottensmeyer, I'd like to turn the floor back to you for closing comments.

[Patrick Ottensmeyer:]

All right. Well, I can't think of anything left unsaid at this point. So. thank you for your time and attention and we will talk to you again in about three months. Thank you.

[Operator:]

This concludes today's teleconference. You may disconnect your lines at this time, and we thank you for your participation.