Kansas City Southern
Q3 2014 Earnings Call Transcript

Published: 17 Oct 2014

[Operator:]

Greetings and welcome to the Kansas City Southern Third Quarter 2014 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (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 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, 2013, filed with the SEC. The company is not obligated to update any forward-looking statements in this presentation to reflect future events or developments. All reconciliations to GAAP can be found on the KCS Web site, www.kcsouthern.com. It is now my pleasure to introduce your host, David Starling, President and Chief Executive Officer for Kansas City Southern. Thank you. Mr. Starling, you may begin.

[David L. Starling:]

Thank you and good morning. Welcome to the Kansas City Southern's third quarter 2014 earnings call. I hope that’s not a bad sign. Included in the lineup of presenters today is Jeff Songer, our Senior Vice President of Engineering and Chief Transportation Officer. Prior to assuming his present position, Jeff served as the company’s Chief Engineer and as such was responsible for directing the capital projects that have significantly upgraded and expanded our track and facilities infrastructure over the last few years. This seems an appropriate time to include Jeff on the call as currently so much attention is being focused on the capacity challenges in the U.S. rail system. We thought it would be benefit for you to hear directly from the person primarily responsible for KCS rail operations and give you his perspective on what we’re doing to stay ahead of the curve. In a subsequent meeting, we intend to have Mike Naatz speak. Mike is Senior Vice President of Operations and Support and Chief Information Officer. He is essential in optimizing the efficiency and productivity of our operations. Jeff and Mike work very closely together to make sure that KCS gets the optimal benefit from its capital projects in the service network. They’ve made an excellent team. As usual, Pat Ottensmeyer, EVP of Sales and Marketing; and Mike Upchurch, EVP and Chief Financial Officer will join me in going over the company’s marketing and financial performance. And Jose Zozaya, President and Executive Rep of KCSM will be available to answer questions pertaining to Mexico. In the interest of time, I’m going to move pretty quickly through my section as one of luxuries of good results, you don’t have to spend a long time explaining things. Revenues for the quarter were up 9% over the last year with revenue in our key strategic growth areas up 19%. As a reminder, we’ve been classifying cross-border intermodal, Lázaro Cárdenas, automotive, crude oil and frac sand as strategic growth areas for KCS. KCS’ operating ratio for the third quarter came in at 66.1, a 1.7 point improvement over the prior year and speaks not only to our business growth but also our system efficiency and cost controls. And finally, our adjusted diluted earnings per share of $1.29 increased 17% from last year’s third quarter number. Going to the next slide, in terms of matching our performance to the 2014 guidance we provided, the comparisons are all good. Our year-to-date volumes are up 5% right in the mid-single-digit range we projected. Revenue growth in the third quarter is up 10%, slightly higher than our high-single-digit projection. But as you can see on the slide, without the extraordinary increase in our grain business, our revenue growth would be 7%. Given that the easy grain comps are now a thing of the past, as we said they would be in October or by October, we are going to stick with our high-single-digit forecast for the year. But as we’ve said before, if rail network congestion eases somewhat, coal could be a bit of a wildcard and be a little stronger than anticipated in the fourth quarter that could affect the fourth quarter and year-end-to-date revenues in a positive way. Year-to-date, our operating ratio has improved 1.8 points from the prior year. As I’m sure you’re aware in September, we slightly modified our operating ratio guidance saying that we felt we’d end the year at the high end of our 1 to 1.5 point improvement. Again, the reason why we are most comfortable sticking with this guidance is that the outsized year-over-year favorability we enjoyed in our cross-border grain business through the first three quarters is behind us now. Last but not least, in the third quarter, we also changed our 2014 adjusted diluted earnings per share guidance from the mid-teens to high-teens growth over 2013. Year-to-date, the improvement has been 21%, which gives us the high degree of confidence that we will meet our revised EPS guidance. With that, I’ll let Jeff Songer provide the operations update.

[Jeff M. Songer:]

Thank you, Dave, and good morning. Turning to Slide 8, productivity as measured by carloads per employee continues to improve. As of the third quarter of 2014, we are handling approximately 30% more volume with fewer employees than in prerecession levels of 2008. While the hiring environment continues to prove challenging, as all railroads are adding resources, we are maintaining appropriate staffing levels to support current volumes and are well positioned into 2015 to continue hiring and training programs to support our growth. Turning to Slide 9, operating metrics for velocity and dwell for the third quarter improved over the prior quarter and KCS continues to outperform the industry average in these performance areas. While these metrics lag those of third quarter 2013 with velocity and dwell performance down 3% and 9%, respectively, overall, I’m pleased with our performance given the handling of record volume levels. Targeted investment in our infrastructure as illustrated in subsequent slides should allow for future improvement in these metrics. Slide 10 illustrates Kansas City Southern’s commitment to invest in our future. In 2014, approximately 52% of our total capital investments will support strategic growth initiatives. This category includes capacity projects to support crude oil, intermodal and cross-border volume as well as a procurement of additional locomotives and rolling stock. While investment in core maintenance will begin to normalize, we will continue to focus on maintaining a safe and efficient infrastructure to minimize disruption caused by slow orders and equipment downtime. Other maintenance projects such as our track infrastructure upgrade between Monterrey and the U.S.-Mexico border will allow for increased velocity in this critical segment. Lastly, I would like to thank our operating team for safely and successfully handling record volume levels this quarter and for the hard work and dedication they continue to show each day. Now, I will turn the presentation over to our Executive and Vice President of Sales and Marketing, Pat Ottensmeyer.

[Patrick J. Ottensmeyer:]

Thanks, Jeff. Good morning, everyone. I will begin my comments on Slide 12. As Dave mentioned earlier, we had record revenues and volumes for the third quarter. Revenues were 677.5 million, which was 9% above last year. Carloads increased by 4% to [595.4 thousand] (ph). Revenue per unit increased by 4.7% from last year. Foreign exchange was a slight negative during the quarter reducing revenues by about 20 basis points. As you can see looking at this slide, except for energy, business was pretty strong across our entire portfolio for the third quarter. The major area of the strength during the quarter were automotive, grain, metals and pulp paper. Primary areas of weakness were utility coal, frac sand and food products, which in part was driven by a specific plant outage. I’ll spend a few moments now talking about each of the six key business units covered on this page. First, revenues in our chemical and petroleum business increased by 7% on volume growth of 2%. We had revenue growth in all of the major commodity areas in this business unit led by petroleum, which was 16% higher than last year. Our plastic business was also strong with revenues increasing by about 6% over last year. RPU increased by 5% overall, driven by strength in petroleum shipments primarily in Mexico and strong cross-border volumes which were 11% higher than last year. As you all know, we report crude oil in our energy business units, so petroleum here is primarily refine products and derivatives. In our industrial and consumer business, we generated revenue growth of 11% on a 6% increase in carloads versus last year. As was the case last quarter, our metals and scrap shipments were strong with revenues in this business up by 13% on volume growth of 8%. We have very favorable mix drivers here as a result of new business with length of haul increasing by almost 6%. Automobile production and drilling activity were the main drivers for this business. We also saw strength in pulp paper and shipments of military equipment, which is more likely going to be a temporary situation. Our ag and minerals business had another strong quarter with revenues and volumes increasing by 8% and 5%, respectively. We began to see the trend that we’ve been telling you about for some time now finally emerge as the year-over-year comps began to return to more normal patterns. You may recall that revenues in this business were up by almost 36% versus last year for the first six months. All of the growth areas in grain and specifically cross-border grain was increased by about 20% versus last year. As I mentioned earlier, our food products business recorded lower volumes and revenues due in part to a temporary outage at a plant we serve. Moving on to our energy business, revenues declined by 4% on a volume decrease of 3% versus last year. The main driver here was utility coal where revenues and volumes were lower than last year by 4% and 6%, respectively. This is a particularly weak third quarter given that this is normally the peak demand period for our service region. As I will mention in a few minutes, we expect year-over-year performance will improve for the fourth quarter, again partly driven by easy comps to the fourth quarter of 2013 but also driven by a replenishment of stockpiles that we expect to occur at some of the plants we serve. Eight out of the nine power plants that we serve have reported that stockpiles are lower than desired levels. For the first time since we started reporting separately, our frac sand business declined versus the previous year. Revenues fell by 12% on a volume decline of about 5% versus 2013. It feels like we are seeing some shifting in the destinations to the Bakken region possibly due to some seasonal and weather-related factors. In addition, we’ve heard that shippers and sellers are favoring unit train destination terminals. Many of the terminals we serve in our handle units range currently, we don’t believe we’ve seen the end of our growth period for frac sand and some of these factors will shift in the future to our favor. In fact, we have seen a return to growth so far in the fourth quarter in frac sand. After three consecutive quarters of decline, our crude oil business returned to a very strong growth trajectory during the quarter with revenues growing by 34% on volume growth of almost 47% from last year. Much of our growth in this quarter was related to deliveries to a terminal that’s a Port of Beaumont, which we began to serve this summer. I’ll talk more about the outlook for crude oil in a few minutes. Next, our intermodal business continued its strong growth profile with revenues increasing by 11% on an 8% growth in units. As you can see in the appendix in today’s presentation, cross-border intermodal revenues grew by 16%. Revenues related to our Lázaro Cárdenas business grew by 20%. This Lázaro growth was encouraging returning after five consecutive quarters of single-digit growth rates at Lázaro. Our U.S. domestic intermodal revenues related to the Dallas, the Southeast business grew by 23%. Finally, our automotive business continued its exceptional growth trend with revenues increasing 28% on a 22% increase in carloads. This growth was primarily driven by new business with about 40% of our revenue growth in the quarter was attributable to the three new plants that opened recently in Mexico. We also experienced growth in imports and exports due to the port of Lázaro Cárdenas. Cross-border revenue grew by 79%, again driven primarily by the new auto plants opened in Mexico earlier this year. Moving to Slide 13, here we show our cross-border revenue trend and you can see that we reached an all-time record at $167 million during the quarter, which was 14% higher than last year and about 4% higher than the previous record, which was in the fourth quarter of 2013. We saw cross-border revenue growth in all business units except energy which is relatively small with particular strength in automotive, which was up 79%; intermodal, which I told you earlier was about 16%; and ag and minerals which was about 20%. Moving to Slide 14, you will see a different display of the five strategic growth areas that we’ve shown you in the past. We’re beginning to follow the model of our cross-border trend chart that you saw in the previous slide. So you can see over time how these five key growth areas have performed and the trends in both total revenue and percent of revenue that in aggregate they contribute. As Dave mentioned earlier, the punch line is this. In total, these five growth markets grew by 19% and were responsible for about 20% of our total revenues. This includes the impact of a 12% reduction in frac sand revenues that I discussed earlier. Just so you don’t lose anything in the conversion, the growth rates in the other four groups were as follows. Crude oil grew by 33%, cross-border intermodal by 16%, Lázaro Cárdenas by 20% and automotive by 28%. The total revenue generated by these five groups was about 138 million and was an all-time high for the quarter. Moving on Slide 15, as you can see on the market update here, we have not changed our full year outlook for any of our six major business units from what we reported at the end of the second quarter. Furthermore, as Dave Starling told you earlier, our guidance for the full year revenue and volume growth on a consolidated basis remains unchanged and that guidance is for mid-single-digit volume growth and high-single-digit revenue growth. With the exception of energy and ag and minerals both which I’ll talk about in a moment, our current 2014 full year revenue outlook is very much in line with what we reported for both the third quarter as well as nine months year-to-date. We see nothing on the horizon for the rest of the year that would change our full year guidance in those areas. In the case of energy, revenue for the third quarter as well as for the nine months year-to-date has been below 2013 comps due largely to declines in utility coal and crude oil. We are expecting both of these commodities to show stronger comps during the fourth quarter, reversing the year-to-date declines to show single-digit growth in freight revenues for the full year. We expect our utility coal customers will replenish their stockpiles from somewhat depleted levels during the fourth quarter and that will drive positive comps in utility coal for the fourth quarter. The opening of new crude oil terminals on our networks to which we are delivering trains today will drive the positive comps versus last year in that area. We believe the combination of those two factors will drive full year revenue in this business to be slightly positive to 2013. You may recall that last quarter, we increased our full year revenue guidance for ag and minerals from single digit to double digit, based primarily on the strength of grain shipments for the first six months of 2014. As you saw earlier, revenue growth in this business for the third quarter was at 7.2% and we are expecting the fourth quarter comps to be slightly lower than last year due to the exceptionally strong fourth quarter we had in 2013. So the trend has performed very much like we expected over the course of the year, very strong comps in the first six to eight months, then declining as we move into the end of the year. This is very much in line with what we have been saying to you all year. When you put all that together, we still feel comfortable with our current outlook for double-digit revenue growth for the full year. I’m not going to cover any of the other business units in any details and our outlook remains unchanged from prior reports and very much in line with actual performance so far this year. I will conclude my comments on Slide 16. We see no significant changes in the positive economic outlook in either the U.S. or Mexico for the remainder of 2014 or as we begin to look into 2015. There are certainly reasons to be cautious about the global economy but business demand feels good to us and the outlook for the North American economy continues to be positive. I’ve already covered the outlook for grain and coal in some detail, so I won’t repeat it here. Growth from our strategic growth areas continues to be strong and it was encouraging to see the business at the port of Lázaro Cárdenas pick up during the quarter. In spite of recent weakness in crude oil prices and spreads, we still feel good about the prospects for long-term growth in our crude by rail business. New terminals are being build in our service regions and as we said for several quarters now, the demand for heavy crude from Western Canada to the refineries in Port Arthur in Beaumont area will be the key driver to our long-term growth. I don’t have a bullet point on this page about pricing but we believe the pricing environment continues to be positive and expect that increases for the foreseeable future will be above inflation. If we look at all of the contracts and rate quotes that were renewed during the third quarter, our weighted average rate increase was about 5.3%. The dollar value on which this average rate adjustment applies represented about 10% of our annual revenue base. As I explained last quarter, this is different than same-store sales and that this is an indication of the expected impact of rate negotiations which took place during the quarter and might have on future revenues. Finally, I’ll close by saying that our new business pipeline remains very strong and is growing and we continue to feel very good about the long-term growth prospects ahead of us. With that, I’ll turn the presentation over to Mike Upchurch.

[Michael W. Upchurch:]

Thanks, Pat, and good morning, everyone. As Pat previously indicated, volumes increased 4% and revenues 9% in the quarter. Our operating ratio improved 170 basis points and incremental margins were 52% in the quarter. Reported and adjusted diluted earnings per share were both up 17% and we’ve provided a reconciliation between reported and adjusted in our appendix that primarily represents differences in FX impacts and debt retirement costs. Our adjusted EPS increase is predominately from increases in operating income and a small tax rate benefit year-over-year. The adjusted effective tax rate for the quarter was 33.6% and that’s consistent with our guidance we provided and we would expect to continue to see a 33% to 34% tax rate for the full year. You can find more details on the P&L taxes and foreign exchange in the appendix. Moving to Slide 19 represents a summary of our operating expenses and key drivers behind year-over-year increases that we experienced in the third quarter of 2014. Overall, expenses were up 6% versus revenue increases of 9%. As you can see in the bar charts, all expense categories increased year-over-year with the exception of equipment costs, which continued to decline as a result of our lease asset purchases. We’ve experienced an $11 million or 30% decline year-over-year in equipment costs. In the table to the right, you can see approximately half of our expense increase is volume related, from expenses of fuel, compensation and other directly variable costs. We did see headwinds from higher incentive compensation, depreciation, wage inflation, track maintenance and I’ll cover those in more details in the next few slides. On Slide 20, our quarterly average headcount increased nearly 3% but continues to achieve near our longstanding goal of maintaining headcount growth below volume growth. Our volume-based compensation expenses were up 5 million in the quarter, wage inflation contributed to a $4 million increase in compensation expense and better-than-expected year-to-date results with our plan led to increased incentive compensation expense of $4 million. On Slide 21, purchased services increased 7 million or 12% year-over-year. The majority of the expense increase is related to track maintenance for activities such as rail grinding and testing and bridge repairs. The remainder of our purchased service increase is attributable primarily to volume-sensitive costs such as car repairs, switching and to a smaller degree intermodal lift charges. Turning to Slide 22, fuel expense increased 6 million or 6% year-over-year. Carload increases drove the majority of the change in fuel as the average price per gallon increased only slightly. However, consistent with trends we have seen over the last year, fuel prices continued to decline in the U.S. 7% year-over-year while fuel prices in Mexico increased nearly 11% year-over-year. And specifically our price per gallon in the U.S. was $2.93 a gallon in the third quarter of 2014 and $3.29 in Mexico. And because of the rising prices in Mexico, our fuel lag benefit was only $900,000. And perhaps just some additional color on future trends that we would expect in fuel prices for our Mexican franchise. The stated policy is to continue to increase fuel prices 3% per month through the end of January and then to try to maintain flat prices through the rest of 2015. On Slide 23, you can see our equipment costs declined significantly 30% year-over-year and is the direct result of our leased asset purchase program, which to-date has included over $600 million of cumulative purchases. As you can see in the two tables, the equipment purchases resulted in reduction of equipment costs of 8 million, which was partially offset by 4 million of increased depreciation. It’s also worth noting that year-over-year, we saw a $3 million benefit in car hire, again largely a benefit from owning equipment rather than leasing equipment. Finally, our heavy capital investment program continues to cause some headwinds in depreciation, which increased 4 million year-over-year. Finally, on Slide 24, I’d like to review our capital structure and cash flow priorities. As we have been communicating for some time now, our first priority continues to be to invest in the business and accordingly we are still on track to invest 28% of our revenue in supporting in the growth opportunities. Our focused investment strategy has allowed us to grow our volumes by almost 30% since prerecession levels and staying ahead of growth opportunities by investing in the future will continue to be our focus. Our Board of Directors will also continue to evaluate our dividend strategy on an annual basis, but we currently do not anticipate material increases in the dividend. And given the magnitude of our investment opportunities, we do not believe stock repurchases are in our foreseeable future. Finally, we continue to optimize our capital structure by purchasing assets under lease or if leases expire, but we currently own 51% of our equipment that’s up from about 20% two or three years ago and we’ll continue to try to get closer to industry averages of approximately two-thirds ownership. Our overall debt structure is one we’re quite comfortable with and we currently enjoy an industry best average effective interest rate of 3.2%. With that, I’ll turn the call back to Dave.

[David L. Starling:]

Okay, thank you, Mike. Can’t resist this closing remark, I’m sure all our friends on the call are supporting America’s team, the Kansas City Royals, so Go Royals. Now, we’ll be happy to take your questions. I would like you to limit them to one. We have a lot of people in the queue we want to be able to take everyone’s call, so please limit it to one question.

[Operator:]

Thank you. We will now be conducting a question-and-answer session. (Operator Instructions). Our first question comes from the line of Allison Landry with Credit Suisse. Please proceed with your question.

[David L. Starling:]

Good morning, Allison.

[Allison Landry:]

Good morning. Thank you. Congratulations on good results. So I wanted to talk a little bit about crude. Obviously, there has been quite a bit of market jitters surrounding the drop in [Brent] (ph), but I wanted to get a sense on whether you have a view in terms of heavy Canadian crude a little bit more insulated perhaps in Bakken or Texas crude just given the enormous sunk costs in oil’s end? And then as a follow-up, are you signing any customer commitments with your new partner to bring down the heavy Canadian crude to some of the destination facilities that are coming on line now?

[Patrick J. Ottensmeyer:]

Allison, this is Pat. I’ll answer your question. Yes, we do feel that the Canadian crude is going to behave a little bit differently. Obviously preparing for the call we’ve talked to a couple of our major crude partners and customers just in the last couple of days and the markets are always going to be volatile, they’re going to be subject to economic and political factors that are beyond our control. There’s just a huge amount of investment that is going into this business and we don’t see anything fundamentally changing for the longer term outlook. Regarding your question about commitments with our partner, we actually have multiple partners. I think that’s an important thing to make sure everyone understands is we’ve talked a lot about the Global Partners deal at our facility at Port Arthur, but we have other facilities that we’re serving for crude oil. And yes, we will have contracts and commitments in place. We’re negotiating a couple as we speak. So that will take a little bit of risk out of the equation and give us some better visibility to the outlook for the years ahead. But based on the facility that we serve, based on the commitments that are being negotiated or in place, we still feel that 2015 and beyond are going to be very good growth years for our crude oil business. The Port Arthur market is large and it wants to import the heavy crude and we think rail is going to be a good solution for the long term.

[Allison Landry:]

Perfect. And then just maybe switching gears a little bit, you mentioned a slight FX headwind and I know that the automotive business is more highly exposed to the peso. So could you talk about whether there was a material revenue impact there?

[David L. Starling:]

No, there wasn’t. It was very modest in the quarter.

[Michael W. Upchurch:]

Allison, there wasn’t much of an operating income impact either because we have a bit of a natural hedge there with revenues and expenses in pesos offsetting each other.

[Allison Landry:]

Okay. Thank you so much for the time.

[David L. Starling:]

I’m sorry to just remind everyone, please one question. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Bill Greene with Morgan Stanley. Please proceed with your question.

[Bill Greene:]

Yes. Hi, there. Good morning. I don’t know if I should address to Mike or to Jeff but headcount, 3% growth. I think that’s one of the higher growth rates we’ve seen in quite some time. Can you talk a little bit about productivity? Is this sort of getting to the end of that? You’ve had very good margin performance, so how do you think about what’s going to go on with headcount and costs going forward? That would be helpful. Thank you.

[Jeff M. Songer:]

Yes, this is Jeff. I’ll respond to that. The headcount of 3% is fairly (indiscernible) credit cost with U.S. and Mexico and primarily for T&E crews. So as the volume continues to present itself, we will certainly staff accordingly. I think we’re positioned well with the headcount levels we’re at but also hiring and training programs that are underway and will continue to support the growth, I think we’re in a good position.

[David L. Starling:]

I’ll just add to that, Bill, some of the interchanged programs we’re having are because there are now crews available and we’re just not going to get ourselves in that situation.

[Bill Greene:]

That makes sense. Are you able to estimate how much inefficiencies cost in the quarter?

[David L. Starling:]

No, we’ve talked about it but it’s really impossible. And the other thing we are an only system and we’re trying to work together as a system. All the railroads – to make ourselves more efficient. This is not about competition. It’s about keeping the whole rail system fluid, so I don’t think it’s really worthwhile to sit down and try to figure out what all those costs are. I’m sure there’s some costs on both sides.

[Bill Greene:]

Yes, makes sense. Thank you.

[Operator:]

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

[Scott Group:]

Thanks. Good morning, guys.

[David L. Starling:]

Good morning, Scott.

[Scott Group:]

I want to ask about pricing. Pat, I think you mentioned renewals in north of 5% and last quarter was more in the 3.5% range. So is this an inflexion and capacity has gotten tighter and we can really start pushing pricing more aggressively or is this kind of just a one-off, just want to get your opinion there? And then do you have any color – is this more of an improvement in the U.S. or Mexico?

[Patrick J. Ottensmeyer:]

I think it’s pretty similar in both U.S. and Mexico, Scott, and it’s going to – if you look at the trends month-to-month, quarter-to-quarter, we’re going to see some bounciness, so to speak, in the pricing trends. And as I mentioned, the 5.3 covered about 10% of our total portfolio. So in any given month, in any given quarter it’s going to depend on the nature of the business that we’re re-pricing obviously the competitive aspects of that business. But clearly capacity is tied across all modes of transportation and rates are increasing and our primary focus is to improve our service levels through our capital spending and resources as we spend money and invest capital, we’re got to earn a return that supports that investment and reflects the market around us. So feels like the pricing environment is going to be good for the foreseeable future.

[Scott Group:]

Okay, great. Thank you, guys.

[Operator:]

Thank you. Our next question comes from the line of Chris Wetherbee with Citi. Please proceed with your question.

[Chris Wetherbee:]

Thanks.

[David L. Starling:]

Good morning, Chris.

[Chris Wetherbee:]

Maybe just a question on the process of Mexican legislation, just want to get an update on where we stand. I think we are potentially expecting something maybe this month with a passage potentially in November, just sort of an update on that. Maybe how the bill is looking as it stands right now. Any changes from sort of the working assumptions that it’s going to be a little bit different than was initially passed in the House of Deputies back in February?

[David L. Starling:]

The only thing I can say at this point is yes, it looks like it will be different. We believe that Mexico definitely understands how important the railroad is to the economy and we feel like the way they’ve treated us the last years, they always have had a respect for the rule of law, so we are moving forward on that basis. But we really don’t have anything to report at this time.

[Chris Wetherbee:]

And timing is far to tell at this point?

[David L. Starling:]

Correct.

[Chris Wetherbee:]

Okay. Thanks very much for the time.

[Operator:]

Thank you. Our next question comes from the line of Tom Wadewitz with UBS. Please proceed with your question.

[Tom Wadewitz:]

Good morning. Good results but I’m going to ask you about something else since I got one here. Dave Starling, I wanted to ask your view on consolidation in the industry and whether you subscribe to the view that it could be beneficial to fluidity and capacity if you had some consolidation?

[David L. Starling:]

That’s the only thing I can say. First of all, we don’t operate in Chicago, so we’re not a part of the issues that are happening in Chicago. So I really don’t know – I’m not an expert on CSK or CP if that actually would provide fluidity or not. I just do know that in the current environment of congestion, I think it would be very hard to the regulatory bodies or even the shippers to get any kind of merger acquisition through that didn’t alleviate some of the congestion to satisfy the shippers. So that’s all I can say.

[Michael W. Upchurch:]

Welcome back, Tom.

[Tom Wadewitz:]

Thank you, Mike. Is there any more discussion at the Board level? Does this naturally kind of stimulate more discussion for KSU about what could happen eventually or is that not necessarily the case?

[David L. Starling:]

Anytime something like this happens we always have a lively discussion with the Board of what are all the possibilities, but as you well know you’ve been doing this a long time, this comes up once or twice a year, at least once a year there’s some kind of discussions. We keep the Board updated on what the possible consolidations could be, but again and back to the original statement, unless there is a clear understanding that capacity would be greatly improved and that would make the shippers feel better and the regulatory bodies that this was going to be result, I think it’d be a very difficult time for this to happen.

[Tom Wadewitz:]

Okay. Thanks for the perspective. I appreciate it.

[David L. Starling:]

Okay.

[Operator:]

Thank you. Our next question comes from the line of Brandon Oglenski with Barclays. Please proceed with your question.

[Brandon Oglenski:]

Good morning, everyone. Mike, I wanted to ask about your U.S. operating ratio because I think in the past you’ve hinted that, look, it’s going to be difficult to get it out of that low 70s range just given the fact that you are short of haul than a lot of the bigger peers and looking at a lot of the connecting traffic flows on your system, but what are some of the longer term opportunities especially just in incrementally better price and pretty solid volume growth here too?

[Michael W. Upchurch:]

Well, we really look at this as one company and while we do file separate Qs and you can back into those numbers, some of the information that Pat discussed around cross-border, our focus is really to try to increase that as a percentage of our business and drive down our overall operating costs whether it’s traffic in Mexico or the U.S. So I don’t know that we’re going to specifically focus on just doing less here, but we’re going to continue our goal of trying to move the operating ratio down each year.

[Brandon Oglenski:]

Thank you.

[Operator:]

Thank you. Our next question comes from the line of Justin Long with Stephens. Please proceed with your question.

[Justin Long:]

Thanks. Good morning. Congrats on the quarter.

[David L. Starling:]

Good morning, Justin. Thanks.

[Justin Long:]

Dave, I wanted to get an update on equipment. Any changes to your order or delivery plans for locomotives? And I think last quarter you discussed a potential long-term order for railcars. Is there any update on that process and the number of units you feel like you need to add to your fleet over the next couple of years?

[David L. Starling:]

Well, locomotives; I think we’ve already talked about locomotives. We’ve already ordered 85 for this year. A lot of them are being delivered in this back half of the year. In fact we get most of them in the next couple of months and we got deliveries coming in, in the first and second quarter. A lot of that is built around a new crew by rail business that we think we’ll be seeing out of Canada going to the Gulf. Rolling stock, grain cars, there is always automotive cars, but we’re very dependent on GTX to increase the boxcar fleet, double-stacked car fleet and GTX has got a very big order in this year for more cars for the whole industry. We’ll be meeting with our Board, Justin, in November and at that time we’ll be laying out a three-year strategy on car acquisition. So hopefully on the next call we can give you more color on that.

[Justin Long:]

Okay, great. I’ll leave it at that. I appreciate the time.

[Operator:]

Thank you. Our next question comes from the line of John Larkin with Stifel. Please proceed with your question.

[John Larkin:]

Good morning, gentlemen.

[David L. Starling:]

Good morning.

[John Larkin:]

Just had a question regarding the CapEx, which has landed towards capacity additions, fluidity improvements and so forth and continues to sit at about 28% of revenue, which is a good 10 percentage points or so above other railroads to perhaps have property that’s in better shape. How would you see this percentage proceeding forward? Is it going to be tailing off over the next five years, eight years to more of a 18%, 19% level or are we going to be sitting at this level for the foreseeable future?

[David L. Starling:]

Well, first of all, I don’t think that the other railroads are in better shape. But if you look at the CapEx, a lot of the CapEx is being spent for growth as Jeff’s graph noted about 52% has been on growth and we’ve been growing faster and we want to stay out ahead of the volume. The way you stay out ahead of the volume is you have to continue to invest in your network even during times where you the volume may not support it, you’re only going to be wrong for a year and I think that’s being proven now with the volumes coming on and actually our system is fairly fluid. So some railroads are playing catch-up right now. It’s more expensive to do that. You’ve got more dissatisfied customers. So we’re not apologizing for CapEx as long as we have the growth trajectory that we do, then you’ll see the CapEx. The average over the last few years has actually been around 24%. The reason it’s 28% this year is because we bumped up the locomotive order simply because there’s a problem in sourcing locomotives and if you don’t get the order in, when you do get ready to order locomotives they may not be available. So the answer to your question is as long as we’re growing, we’re going to invest a sufficient amount of capital to handle the volume.

[John Larkin:]

Thanks very much for the thorough answer.

[Operator:]

Thank you. Our next question comes from the line of Thomas Kim with Goldman Sachs. Please proceed with your question.

[Thomas Kim:]

Thanks. I’d like to ask on Lázaro. Are you seeing any benefit or do you anticipate benefiting from the core congestion that we’re seeing out in LA, Long Beach?

[David L. Starling:]

I don’t think we’ve seen actual volumes. We’ve seen interest in longer term, some of the carriers shifting volumes for Lázaro particularly to serve the Gulf Coast beyond Houston and maybe some of the markets in the Southeast. So we haven’t seen any actual results, but we’re having those discussions with a few of our ocean carrier customers for longer term decisions and diversions. And as you know, the new terminal that APM is building next year I think is going to open up and change the competitive landscape of Lázaro and we think that could be a driver for more traffic targeted to the U.S. market.

[Thomas Kim:]

All right, great. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Bascome Majors with Susquehanna. Please proceed with your question.

[Bascome Majors:]

Yes, thanks for taking my question. So you addressed forward pricing expectations earlier when talking about renewals, but looking to 2015 specifically can you talk a bit about what kind of visibility you have with the volume growth on the network from there, what variables we should think about for next year and how comfortable do you feel today with sort of the street consensus bar for mid-teens earnings growth into 2015?

[David L. Starling:]

You’re primarily interested in volume or earnings?

[Bascome Majors:]

A little bit of both.

[David L. Starling:]

We’re kind of the final stages of our plan for 2015 and beyond. I’ll speak to the volume growth and maybe Mike can touch on earnings. But a big driver of our volume growth next year is going to be the five key areas that we focused on. Automotive, 40% of our growth this quarter was related to new plants and those plants are going to continue to ramp up in 2015. So barring any kind of event in the economy and affecting auto sales in general which obviously we’re not immune to, we think we got good visibility there. Crude oil, we’ve got new terminals that have opened and contracts that are being negotiated. So we think we’ve got good visibility there as well. So as I’ve said to the team here, we spend a lot of time forecasting and projecting and the only thing I know for sure is that the numbers we come up with are wrong, but you just don’t know in what direction and by what magnitude. I feel like we’ve got a planning process and visibility with our customers that is pretty solid and grounded in reality, so I think we’ve got good visibility into next year on the revenue side.

[Michael W. Upchurch:]

I think on the earnings side we’ll probably hold off until January to give our annual guidance.

[Bascome Majors:]

All right. Well, thank you for the time.

[Operator:]

Thank you. Our next question comes from the line of Ken Hoexter with Bank of America. Please proceed with your question.

[Ken Hoexter:]

Great. Good morning. Go Royals sounds good. Any thoughts on timing of the equipment lease conversions, any big contracts coming up, I guess – maybe talk in terms of scale if you’re looking to go up to 65% from 51%, what does that mean in terms of [OR] (ph) points and capability and again timing on that?

[David L. Starling:]

Yes. Ken, I wish we could give you specific numbers there. We’re still in the process of looking at a number of leases that come up over the next year plus and haven’t made any final decisions on that. So the timing and the magnitude of that benefit are still very much up in the air. But I think as we have said over and over, we think this is a five-plus year journey. We started it in 2011, believe that there is a 200 to 250 basis point overall opportunity ahead of us during that period of time and I think there is still an opportunity for us to continue to drive that operating ratio down and we’re working very closely with Jeff and Mike Naatz’s team and trying to finalize those assumptions. So maybe in January we’ll have a little bit better answer for you there. But rest assured, we want to continue to move that percentage up and get some additional benefit in operating ratio there.

[Ken Hoexter:]

Just to understand that, is it more weighted over time or is there something more specific coming up maybe even in 2015 that we should look out for?

[David L. Starling:]

There are some opportunities in 2015.

[Ken Hoexter:]

Okay. I appreciate the insight. Thanks, guys.

[David L. Starling:]

That Go Royals was spoken only as a true Yankee fan.

[Ken Hoexter:]

The [Jim’s] (ph) of George Brett running on the field.

[David L. Starling:]

We both said the two final teams were not…

[Ken Hoexter:]

The season is already over.

[Operator:]

Thank you. Our next question comes from the line of John Mims with FBR Capital. Please proceed with your question.

[John Mims:]

Hi. Good morning, guys.

[David L. Starling:]

Good morning.

[John Mims:]

Pat, a question for you on chemicals. Obviously, people have been talking a while about the big growth and the build out in the petchem complex in the Gulf region, but I started hearing some rumors and maybe just some chatter about some of those projects being delayed because of labor shortages and inability to get resources down there in that region. Are you hearing that from any of your customers that growth in that segment may be a little bit longer tailed than originally felt or are you still confident in the timeline as far as when those things come on line and we start to see the volumes from the chemical side and the plastic side?

[Patrick J. Ottensmeyer:]

Yes, we are hearing it not as much from customers as we are from other people who are kind of informed and focused on that whole opportunity that’s the whole phenomenon. But we said we don’t expect and we haven’t been very specific about timing or magnitude in terms of the way we have described our opportunity. We’ve talked about it in 2016, 2017. Some of the plants and primarily smaller plants have been built. The large mega-plants, some of them are under construction and we know that that gives us a little better visibility regarding the timing. But yes, we have heard that one of the factors that might constrain that opportunity or limit that opportunity is labor and engineering and other factors that could delay some of those plants. But whether it’s 2016, '17, '18, I think we still feel that there’s going to be a very big opportunity for us.

[John Mims:]

Okay, so no real cancellations or real delay – formal delays right now, it’s still kind of speculation.

[Patrick J. Ottensmeyer:]

Yes, not that I’m aware of. I’m not aware of any plants that have been cancelled but a lot of them are still in the planning stages and the timing is uncertain. And of the companies we’re working with, we’re not being told by them there’s a delay.

[John Mims:]

Okay. Thanks a lot.

[Operator:]

Thank you. Our next question comes from the line of Keith Schoonmaker with Morningstar. Please proceed with your question.

[Keith Schoonmaker:]

Thanks and good morning.

[David L. Starling:]

Good morning.

[Keith Schoonmaker:]

Regarding Mexican auto volume in addition to addition productions coming on line now and the next couple of years, I’d like to hear perhaps some elaboration on additional dynamics that could affect this business over the longer term by assuming other legacy pricing agreements or shifts in length of haul you’d anticipate or decline in traffic that you handoff to it from other locations that the Mexican production would be displacing? Thanks.

[David L. Starling:]

Okay. You managed to get three questions in one. We’re ramping up the plant that were opened earlier this year. I think we talked about last quarter. In the last six months or five or six months, there have been three new plants announced; Kia, BMW and Nissan has another plan that they’re building with coproduction with Mercedes. The Audi plant is under construction in the Mexico City area and they’ll open next year. So again, that’s just pretty phenomenal when you think about it, three new auto plants announced in Mexico in the last four or five months. We think there will be more. We don’t think that this is displacing any traffic. We’ve looked at our parts business and steel and other things to try to understand how this is going to affect the flow and movement of components and parts and other materials used in auto production. We could see some shifting in our intermodal and steel business as sourcing over time becomes more local to where the plants are located as opposed to – for example parts moving from the Great Lakes area down to Mexico which is a big part of our intermodal business today that it’s really hard to see how that’s going to shift. The long and short of it is for a lot of factors that we’ve talked about, the favorability of Mexican manufacturing not just automotive but manufacturing to serve North America and really we’re hearing in the case of the BMW plant one of the factors that they considered was Mexico’s attitude toward free trade. A lot of those vehicles are going to be exported not just to the U.S. but other markets around the world and Mexico’s position regarding free trade is becoming a factor for manufacturers locating there. So all those factors continue to be positive and we think that there could certainly be more automotive plants announced in the foreseeable future and not just automotive but across other industries as well. I’m not sure I satisfied your question, but we certainly see a very positive outlook for automotive growth in Mexico.

[Keith Schoonmaker:]

Thanks. I recognize I snuck a little extra in there but one of them was legacy price agreements or length of haul…?

[David L. Starling:]

Most of the new plants obviously the contracts are fairly fresh, so we feel good about those. There is a big opportunity for us. They majority of our automotive and auto parts business we handle in Mexico and we will have opportunities as some of those legacy contracts expire to move some of that business into our U.S. network. So we’re certain to face formidable competition from the incumbent carriers and so we’re not counting on that in our forecast and guidance, but I believe we will have opportunities and there will be interest for our auto customers to use our network in the U.S. to a greater degree and explore other options. So that is an opportunity over the next few years. The timing probably two or three years out and the likelihood and magnitude is very uncertain and we know that we’re going to face stiff competition.

[Keith Schoonmaker:]

Great. Thank you.

[Operator:]

Thank you. Our next question comes from the line of Tyler Franz with Raymond James Financial. Please proceed with your question.

[Tyler Franz:]

Hi. Good morning, guys.

[David L. Starling:]

Hi, Tyler.

[Tyler Franz:]

Hi. This one might be for Dave or Pat, but just curious about – if you could talk about the impact that the new Wylie, Texas intermodal terminal might have on your intermodal franchise. How does it fit in strategically? Is it just replacing your other Dallas terminal and then maybe when is that expected to come on line?

[David L. Starling:]

Well, that’s one of my pet projects, so I’ll probably give you too long an answer but the facility we had in (indiscernible) was five stub tracks, very inefficient. When a train would arrive, it would take us a couple of hours to get it all spotted. When we got ready to depart a train, we had to have a very early gate because then it took us an hour to get the train altogether to depart it. The new terminal is going to be very efficient. We can yard the entire train. As soon as the train stops, you start making the cargo available. You’ll be able to run a very competitive gate because again your train will be made up, put together, so you can go trackside and load outbound. So not only were we congested, but it was very, very inefficient and just was a lousy intermodal terminal.

[Tyler Franz:]

And it’s mostly focused on domestic.

[David L. Starling:]

That is correct.

[Patrick J. Ottensmeyer:]

And the domestic, we had one month where it grew 16%.

[David L. Starling:]

For this quarter, it was up 23%. So that Dallas to the Southeast market is a good growth market for us and the fact it the (indiscernible) terminal is pretty much tapped out and we don’t call it the speedway for nothing. I mean it is the best route to the Southeast, so we’re seeing more growth with all different types of carriers including the FedEx’s of the world that are gradually moving more cargo through there. Again, it’s a great route. We’ll finally have a modern terminal with an automated gate with all the features a terminal should have today. So we’ll open that hopefully in May. I’m looking at Jeff over here. He’s nodding his head, so we’ll be very pleased, very proud of that terminal. It should be one of our prime terminals in that Dallas market to be the speedway. The other thing that that will allow us to do is we’re going to repurpose the (indiscernible) property and we’re talking to a number of our transload partners as we speak to find ways to put that facility to use for other revenue.

[Tyler Franz:]

Perfect, great color. Thanks.

[David L. Starling:]

Thanks for asking about (indiscernible) and Wylie.

[Operator:]

Thank you. Our next question comes from the line of Cleo Zagrean with Macquarie Capital. Please proceed with your question.

[Cleo Zagrean:]

Good morning and thank you. Coming back to questions asked before about the crude oil and chemical franchises, but to ask about the impact of recent volatility in crude oil prices. Have you seen any reactions from your customers not just crude oil but also frac sand and chemical to this recent volatility we’ve been hearing about just of CapEx caps or delays, any news on that front for you? And if you could discuss the flexibility to adjust your own spending plans just with your customers plan change? Thank you.

[David L. Starling:]

I don’t think we’ve seen volatility yet related to the pricing. Again, our play in the crude oil business is Canadian crude to the Gulf Coast and that business has been growing very nicely for the past several months and this quarter. But we haven’t seen an impact yet. On the frac sand, I wouldn’t say that the impact on our business has been because of pricing. It’s really been more supply shifting and some constraints that I mentioned earlier about our network not having the ability to handle unit trains. But we’re certainly keeping a close eye on what’s going on with pricing and spreads. But all I can say again, I said it earlier that we’ve been in close contact with our customers and partners and there’s just a huge amount of capital that’s being invested to support crude by rail to our service region and it will always be subject to short-term volatility and pricing and spreads and economic pressures. But longer term, we still feel that we are very well positioned and we think we’re going to see good growth for several years ahead. So the answer to your question – the short answer is we really haven’t seen the impact yet of the spreads but longer term, we think the fundamentals are very solid.

[Cleo Zagrean:]

Thank you.

[Operator:]

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

[David L. Starling:]

Okay. Thank you for listening in on our call. We feel like it was a great quarter. We think 2015 is going to be a continuation of our growth here. We’re very encouraged, so we’ll see you at the next call and Go Royals.

[Operator:]

Thank you. This concludes today’s teleconference. You may disconnect your lines. Thank you for your participation and have a wonderful day.