Jan 27, 2008
Executives
E. Hunter Harrison – President and Chief Executive Officer Claude Mongeau – Chief Financial Officer and Executive Vice President James M.
Foote – Executive Vice President of Sales and Marketing
Analysts
William Green – Morgan Stanley Tom Wadewitz – JP Morgan Edward Wolfe – Bear Stearns Randy Cousins – BMO Capital Market Cherilyn Radbourne – Scotia Capital Scott Flower – Bank of America Securities Jacob Bout – CIBC World Markets Bill Mackenzie – TD Newcrest David Newman – National Bank Financial Walter Spracklin – RBC Capital Markets
Operator
At this time I would like to welcome everyone to the Canadian National Railway fourth quarter results conference call. All lines have been placed on mute to prevent any background noise.
After the speakers remarks there will be a question and answer session. (Operator Instructions) Mr.
Robert Morgan, Vice President Investor Relations, please go ahead.
Robert Morgan
Thank you for joining us today, I’d like to remind you about the comments that have already been made in our forward-looking statements. With me today is Hunter Harrison our President and Chief Executive officer, Claude Mongeau, Executive President and Chief Financial Officer, Jim Foote, Executive Vice President of Sales and Marketing.
After the presentation today we’ll take questions from those people that are listening to this. Could you please identify yourself when asking the questions, and in order to be fair can you limit the number of questions to two.
With that it is now my please to introduce to you, CN’s President and Chief Executive Officer, Mr. E.
Hunter Harrison.
E. Hunter Harrison
Thanks for joining us to review predominantly our fourth quarter results, Claude will speak a little bit to the full year results but most of the time will be spent on this quarter. The quarter, I think, was very good considering some of the challenges.
If you look at our revenues adjusted for change were up 4%, carloads were up 5%. Again, we’ll talk about we had the ability to maintain our pricing on momentum.
Our earning, as reported, were up $1.68, adjusted came in effectively flat at $0.90, despite those challenges I mentioned. The precision railroad model continue to work.
The OR compared to last year was effectively flat, I think we were down technically a tenth of a point. There is a few items I would like to highlight that took place, that I’m very pleased with.
One, as you are well aware of we got Prince Rupert opening and running and the service has been excellent. We’re very, very pleased and Jim will talk to you about some of those numbers, of where we see that.
Two, very, very important strategic acquisition for us, EJ&E in Chicago, subject to SBB approval, and we’ll probably have some questions about that, which we’ll be glad to address. And just recently the ANY short line in Alberta which runs Northeast of Edmonton towards the tar sands, and Claude lead that file for us and did an excellent job.
And I think you’ve probably seen the press release, I think we bought the railroad for $25 million and we estimated to put about $130 - $135 million in a capital to get the railroad in the condition it should be. We were successful in two sales of our sale leaseback effect of our central station complex here at headquarters, and of our last remaining shares of BWF, which helped our cash flow performance.
We say further expansion of the non rail services from CN Worldwide North America. And last, but not least, on the labor front I’m proud to announce the first one of these is labor agreement to be signed was announced today.
We reached an agreement, subject to ratification, with UTU and the US on the former IC property, which was the first of the UTU agreement, so this was the first renewal which was completed. In December we completed an agreement that was ratified with IBEW, and then I guess it was last week we announced that our new agreement with the steel workers was ratified, and it was ratified at 85%, which is effectively unheard of.
So some pretty good performance across the board, Claude is gonna talk to us a little more about the details and some of the numbers.
Claude Mongeau
I think it is indeed a good quarter on balance giving some of the headwinds that we had to face, we had during the quarter the Canadian Dollar really rallied and actually settled in above [inaudible] close to $1.02 during the quarter and the oil prices on the world market were above $90 I think actually $91 on average during the quarter. So giving those headwinds we turned in a good performance, particularly good revenue performance if you look at it.
FX adjusted 4% revenue growth, good balance between the pricing and the volume performance. Jim will discuss in more detail, but I’m particularly pleased that we have FX adjusted growth in every business united except forest product which is impacted as we speak by the uncertainty and the housing market in the US.
During the quarter we also closed two very significant transactions, the EWS sales to the German Railroad and the sale and lease back of our complex here in Montreal Central Station. Together they delivered a gain of $155 million, also closed a $465 million of cash flow, so good for ATF and very good for cash flow.
The quarter also had another one time item, the benefit from the lower corporate taxes that’s been announced by the Federal Government here in Canada. BFIT benefit was close to $300 million, if my memory is right, it’s to $284 million, so with this we have EPS, as reported of $1.68, excluding the one-time item, that is the two transactions and the BFIT benefit, the quarter came in at $0.90 which is basically flat year-over-year.
Good growth, good past performance but also a few areas where we had help on the expense side. And I would like to turn to the expense to take that in more detail.
If you look, at the expense performance it’s really two big stories, the clear headwind is fuel expense up a whopping 49% if you look at it on a FX adjusted basis. As I said, WTI at a $91 level, that’s basically last year, WTI was at $60 per barrel in the fourth quarter, it has come down a little bit, so a huge increase on a year-over-year basis.
That’s not mentioning the increase in the refining margin of $3 to $4, which also adds up to the equation. So basically all in with the benefit of exchange you can see an increase for fuel of roughly $100 million, a little bit more than $100 million if I look at FX adjusted.
Helping offset this fuel expense with lower labor expenses a big help here, unfortunately, was the lower stock based compensation. Last year our stock based compensation was a meaningful expense for the quarter.
This year it’s a meaningful credit. On a year-over-year basis it cost to a $80 million reduction, so that’s been helping in terms of lower expense.
And, on the labor line we also are seeing on our labor line the benefits from lower compensation for incentive bonus all of this offsetting a slight increase to our headcount which in the fourth quarter were up basically 2.5% on a year-over-year basis. Purchase services and material and equipment ramp basically well behaved, up 3% on a year-over-year basis, FX adjusted.
Our depreciation is up 8%, this reflects the normal increase that you would see due to our capital expenditure, but also the fact that we have not quite completed, but we have assessed estimates for a new depreciation study of our Canadian assets, and that impacted our quarter by close to $7 to $8 million. A run rate of the increase to our depreciation expense so those categories that we have completed is in the range of $35 million.
This is something in the fourth quarter that we will have to finalize, and I will expect a little bit more expense into next year, on a year-over-year basis we should see an incremental run rate in a range of $40 to $50 million for depreciation. This is as a result of the intensity that we use our assets, the main areas of impact are in the areas of rolling stock, where you would expect the fact that we are using our locomotive and our car fleet much more productively, this is having an impact in terms of life and depreciation rate.
Finally, casualty and other, this is a very lumpy category, as you know, at around $66 million for the quarter. We are, once again basically, would say around $30 million lower than the run rate that I would expect, whatever that means, because as I said it is a very lumpy category.
The reason its lower is because we’ve had continuing benefit in terms of our personal injury reserves both FELA cases, but also occupational disease claims are coming down based on our actuarial study. The benefit during the quarter was around $40 million but we also had a $40 million last year when we did our Q4 actuarial study during the fourth quarter of 2006.
So all in all, good solid performance clearly fuel expense is really little we can do other than cover ourselves with the fuel surcharge, and the help on the labor and fringe benefit. We hope to reverse next year with a better stock performance and an increase in those expenses.
That’s the way we are thinking about it. On free cash flow, we deliver $828 million on the strength of the cash generated from the sale of DWF and Central Station, if I exclude those gains.
But also the significant cash back installment which we did during the year on account of 2006 taxes, something I’ve explained in previous calls, our run rate free cash flow would have been in the range of $650 to $675 million. And, as you know we paid during the year, basically $860 million in cash taxes, because we paid both the 2006 installment and our normal installment now that we are cash tax payable on account of 2007.
This is a headwind we will not see next year. The cap ex for the full year ended up at a $1,680,000,00.
$80 million of that is just a sale lease back portion of our Central Station, so if I exclude that, our cap ex is coming in line with guidance at around $1.6 billion. We see next year’s coming down, we have a number of our programs have been completed, and we’re really focusing and targeting our cap ex next year to the areas that can deliver benefits to us in terms of productivity or growth.
We see our cap ex envelope in 2008 in a range of $1.5 billion, and that will include roughly $70 - $75 million as the first of the ANY capital upgrade program that Hunter referred to. That’s the line that links us to the Lakeland Waterway, which connects us to Edmonton.
Basically the only other item that went up in terms of cash consumptions significantly is the dividend, as per the increase, the Board has decided last year. I am very pleased to report that our Board of Directors again, that is the 12th consecutive year that they’ve done so, agreed to increase our dividend on a go forward basis.
As you will see in the press release, the stock dividend will increase by 10% which should put us at about our target at a 25% payout ratio, give or take going forward. Just a few words on the full year, if I exclude the one time items we came in on the strength on the revenue performance around 3% FX adjusted growth, that’s 340 of earnings per share for the full year, which is flat year-over-year.
I think it is fair to say this is solid performance, we had our share of challenges to deal with, with a much slower economy, particularly impacting forest product, but also if you recall in the first quarter labor disruption and a number of other challenges to deal with, not the least of which are exchange and fuel price volatility. So on balance that 340 I think is a very good performance and that’s the basis upon which with some trepidation I would like to close my presentation with giving you a bit of guidance on 2008.
If you recall at our Q3 call we had reserved the guidance because we thought there was a little bit too much uncertainties to make a call. I must tell you yesterday, and this morning when I was seeing world markets and the volatility that we are seeing, I guess the volatility has not fully lifted, but it is our view basically that in this uncertain environment it’s our view that the economy in actual fact may not be as feared by some in a full blown recession.
I think we still have a good chance of having a soft landing, it maybe a little bit more bumpy, but what we are calling for is a soft landing basically on the order of just below 2% North American GDP growth, 1.7% to be exact. The dollar has settled back in at a range of $0.95 to a dollar, that’s the Canadian dollar versus the US Currency and fuel prices, last I checked were around $90 per barrel and with a forward for the year within that range.
So of course these items have been all particularly volatile and the economy remains a question mark. But if we are calling it right, we think we are very well positioned and, Jim will give you some more detail, we see top line growth next year being the engine of our EPS growth, and clearly we will need it because there are some headwinds that we are facing.
To be specific we are calling for growth of 6% to 8%, which is really around 10%, adjusting for exchange. This will be needed to help us offset some of the headwinds that we are facing.
Let me give you just a few, the foreign exchange fits in that range, say mid-point should have an impact on our reported ETF, Canadian dollars, were in range of 2% to 3%. The fuel at $90 would be and headline increase on the order of $175 million.
The important points for you to know is that at about $40 million, perhaps even $50 million is the fact that our crack refining margin, we have some very, very good contracts in the pass where the refining margins were well below market, these have been renegotiated at market. We are also not always getting the full benefit of the exchange depreciation when we pay our fuel bill, particularly in Western Canada where there is a very tight supply, so net net we see independent of fuel price, that is the movement in WTI, we see a headwind in a range of $40 to $50 million that will be there on the fuel expense.
Labor we hope to turn around, because we hope to have a good year and see the stock price go up. We also have lower bonuses than we would have liked in 2007 and are fully intent on changing that for next year, that’s a headline.
Both of them will be offset somewhat by a lower pension expense. Labor expense next year should be a headwind, again, in a range of 1 to 2%.
So basically, if I look at some of these items and focus also on depreciation and some of the benefit on the personal injury reserve that we had in 2006 and 2007 and should come down a bit in 2008; we are facing cost headwinds which basically spring up in terms of guidance, mid to high single digits given the parameters and the environment in terms of assumption. That will be backed up with very good cash flow generation next year, we’re targeting $750 million of free cash flow and the key uncertainty at this point is whether we are calling the economy right.
But you should know that under Hunter’s leadership, we are managing and getting ready for both scenarios, we want to be there to accommodate the growth and if it’s there and improve our top line, we will be ready and also managing our expenses if the economy turns out to be tougher than what we’re calling at this point. With that I will turn it over to Jim.
James M. Foote
Thank you Claude, as usual I’ll the discussing the revenue numbers on an exchange adjusted basis. In the fourth quarter we had revenue growth of about 4%, there was a good blend of volume in price across all business segments, in total our carloads were up 5% and revenues ton miles up 3%.
These total numbers show the impact of a 45% increase of iron ore loads moved, this year versus last year. All of our iron ore companies were back in full production this quarter versus last year when there was an explosion at a mine and two furnace outages.
So there are a lot of ore loads here but on average they only move about 60 miles so that they do not have nearly the revenue impact. This high volume low revenue per car moved impacts the revenue ton miles, revenue per carload and length of haul as well.
On the price side of the business, the price environment continues to be solid. Rate increases on a per unit basis achieved this quarter were above 4%.
Going through the various business segments, petroleum and chemical up 11%, petroleum related markets continue to be strong, up 16% in the quarter led by [inaudible] shipment into the oil sands region of Western Canada. Strong shipment of fuel oil and diesel fuel and very strong shipments of sulfur, due to the strong price commodity prices and increased world demand.
Chemical side of the business also very good, up 8%, especially imported methanol shipment over the Port of Kitimat on the West Coast. The metals and minerals group up 11%, all sub groups in the metals and mineral segment posted increases, in addition to the iron ore business that I talked about in my opening remarks.
Positive results in all of the metals sub groups, strong demands for steel slabs, plate and aluminum. C0nstruction materials were somewhat stronger in the fourth quarter than they had been earlier in the year and very good shipment of dimensional load, such as windmills and large pieces of machinery in the quarter.
Forest product the only business unit where we saw a decline this quarter. Lumber and panel producing customer continue to face difficult markets, their rationalizing capacity and curtailing production if demand continues to decrease.
Carloads in this area were down 12 and 25 %, respectively for lumber and panel. Paper results down 8% largely due to the closure of a significant mill in Eastern Canada which had just started operations earlier in the year.
And, wood posted relatively flat volumes versus last year, but export prices stayed very strong throughout the quarter. Our automotive business segment up 7%, a very solid quarter performance, finished vehicles and vehicle parts up 5% and 11%, respectively.
Gains there in the finished vehicle segment, driven by new vehicle models as well as very strong import traffic through the port of Vancouver. On the bulk side of the business, bulk in total 8% as the demand for our services from our bulk customers continues to be solid and growing.
Canadian coal, coal in total up 12%, but Canadian coal, again a very strong quarter, up 44% driven by strong demand for the metallurgical coal to the export markets, coupled with new mind capacity which didn’t come on in Western Canada. The US coal business down 10% from short term production issues at a major Illinois basin line as well as an outage at one of the utility served by CN, a short term related issue here affecting the US business.
Grain and fertilizers, the total there up 7% in Canada lower volume of wheat offset by a very strong demand for barley to export, as well as stronger volumes of peas in the West and in the US. We saw somewhat lower corn shipment, big volumes of ethanol and DBG commodities, as well as more soybeans moving to gulf port export markets.
Fertilizer segment, very positive as we continue to move more potash from Canada into the US market where the crop size continues to increase. On the intermodal segment up 4% in total, overseas up 6% reflecting the opening in the quarter of the new Prince Rupert traffic.
Service there has just been phenomenal to all the destinations, as well as we continue to show gains with other steam ship companies over the port terminals in Vancouver. Our domestic business also is showing strong increases with our retail customers in the fourth quarter.
Domestic up 3%, and the other revenue up 7% showing the increase there, activities related to non-rail transportation services. Of course, I touched on the outlook for 2008 from a top line perspective.
There is nothing out there that would shake my confidence in the pricing area. Our pervious guidance in the 4 to 5% unit price increase continues.
We will see a very good growth in virtually all of our business segments, especially intermodal and bulk. On the bulk side our coal outlook is very strong in the US as the Illinois basin coal that we talked about in the as past, as the new minds there come on line, as well as the continuing demand for Canadian metallurgical coal to offshore markets.
Corn demands and corn pricing in the US is very strong. Wheat exports out of Canada continues to be very strong.
Potash movements should continue to be moving into our US markets, as well as strong demands for sulfur in intermodal. In the merchandise segment, the area where we saw softness or decline, it’s difficult to say that forest products were soft this year, it was down quite a bit.
We think that the housing market is probably stabilized and the run rate that we saw in December will probably be where they were, and will continue to be throughout the year. But$, the strong opportunities that we talked about with more and more products moving into and out of the oil sands, very good outlook for 08, for metals and minerals, especially for the full year that demand for iron ore.
If you add that up top line outlook at this point and time, we would certainly expect to achieve 10% top line growth in 08 on an exchange adjusted basis. Hunter.
E. Hunter Harrison
Let me kind of wrap up 07 by making these comments that Claude alluded to earlier. I think if you look at the performance as coming in effectively flat adjusted $3.40 and you take into account that that was comparing 2007 to 2006, this was a world record fall of course.
With obstacles that this team faced in the first quarter with unprecedented weather in Western Canada, the worst in history, with the unfortunate work stoppage by the UTU which set us back, and then the continuing strength of the Canadian dollar and the weakness in the forest product segment; if this had not been a strong operating team we would have not have been able to produce those types of results in the face of those obstacles. So I was overall very pleased with the performance this organization put together.
So looking ahead, you know it’s been very difficult for us, as Claude also mentioned earlier, to try to figure where to stick the pin in with the volatility of some of the issues we went through. But all things in and I would just say this, I’m very optimistic about us being able to achieve those type things.
I think we’ve got several initiatives in our pipeline that can produce some results for us and so I’m looking forward to a real bounce back in 2008 despite some of the things we read every day. We targeted capital spend for productivity and to accommodate additional growth at $1.4 billion, I guess that’s $1.5 billion because we have the ANY added in.
Originally it was going to be $1.4 billion which is backing off about $200 to $300 million from where we had planned on being in 2007. Keith Creel and Paul Miller our Chief Safety Officer are leading us in a real commitment to take full advantage of the opportunities that this whole safety loss control risk management efforts gives us.
And, we will continue to be focus on rewarding shareholders, as Claude mentioned, was just approved today by the Board of Directors, our 12th consecutive dividend and we will continue with our aggressive share buyback program which has been going on for several months now. So all in all I’m very pleased and Operator with that we will be happy to address questions the group might have.
Operator
(Operator Instructions) Your first question comes from William Green from Morgan Stanley.
William Green – Morgan Stanley
The first questions was just related to the productivity. Given the volume growth we saw I would have thought it would have been a little bit better in the fourth quarter, measured in carloads per employee, but maybe that’s not the way to think about it and so I’m curious what your thoughts are there?
And then, how much better can it get? Have we hit a ceiling or are some of these agreements you’re trying to put into place, can those move the needle materially from here?
E. Hunter Harrison
And you’re speaking of labor agreements?
William Green – Morgan Stanley
Yeah.
E. Hunter Harrison
Well I mean they can certainly move the needle. Keep in mind that I have always said that we’ve not been obsessed with the operating ratio, we’re trying to grow this business.
And, there is some initiatives we’ve got going on: one, the NCN Worldwide which is a startup business which we account for differently which show some deterioration. But I guess the biggest issue from those metrics that you’re looking at is that when you lose the amount of lumber business that we had in Western Canada that was our largest segment which now has dropped down enough that grain in Canada and intermodal are larger than forest products.
So it effects the train productivity, it affects a lot of things, but we have certainly not hit the ceiling as far as the ability to produce an improved productivity on our operating metrics.
Claude Mongeau
I would add Bill that basically I think we have had a slight increase in our headcount for the reasons that we discussed on our third quarter call. Some of this is replenishing our crews in the West in particular, some of it is in sourcing, but the reality in terms of getting leverage, the beauty is when you have a better volume outlook going forward, take Rupert for instance, and all the initiative that Jim talked about, the ability to handle the business at lower incremental cost is when it’s easier to show productivity from headcount standpoint and from a labor productivity that you’ve been accustomed to in the past.
William Green – Morgan Stanley
Okay, and then with regard to your outlook, you mentioned in particular you don’t have a recession in your numbers. Can you give us some sense for what you think this sensitivity would be if you had to move toward a more consensus view that maybe perhaps there would be a recession?
Claude Mongeau
You know consensus view is tough to call. If you asked me yesterday it seems the market was calling for a clear recession, today I think people are not sure anymore, that’s the difficulty in the volatility that we see going forward.
All I can tell you is we have initiatives that are fully independent of the economy. Rupert, some of the bulk business out west, some of the initiatives we have to take in market share again, truck, etc.
For sure if there is a recession that will have an impact on our top line, but on balance that may also help with the exchange, it may also help with fuel price and who knows our focus will be on doing the best in those circumstances and rebound strong when the economy comes back.
Operator
Your next question comes from Tom Wadewitz from JP Morgan
Tom Wadewitz – JP Morgan
I wanted to see first if Claude could give us some insights on some of the moving parts on comp and benefits in your 08 outlook? You talked about pension and that might be down year-over-year and on the incentive comp, can you give us a sense of the stock base and the incentive comp that was actually paid out in 07 and what that number might have looked like in 06 just so we have a little primer for understanding some of these moving parts?
Claude Mongeau
2006 was a stellar year Tom, so you know we blew the lights out, and we had the highest possible bonus as a team, 2007 was tougher and in the end the Board recognized that and we did not get a bonus. Next year we’re gonna have to replenish, we’re shooting for a stretch and hopefully we’ll get a stretch.
That alone, having said this, might be an increase in terms of expenses in the range of $60 million, perhaps $65 million which about the benefit that we will get on pension because of the higher discount rate. So the two of them offset hopefully and the real impact will be the stock based compensation that could be as things rebound and goes as one would expect, could be in a range of $40 million to $50 million increase.
Tom Wadewitz – JP Morgan
What’s the $40 - $50 million increase?
Claude Mongeau
Broad base compensation, if the stock performs the way we would expect it based on expenses.
Tom Wadewitz – JP Morgan
So you got a $60 to $65 million potential increase in incentive comp and then on top of that $40 or $50 million from stock base?
Claude Mongeau
That’s correct, offset by a reduction in pension expense in the range of $60 to 70 million.
Tom Wadewitz – JP Morgan
And it was kind of a 100% payout in 06, and a 0% payout in 07 was kind of the way it worked out?
Claude Mongeau
That’s awful close.
Tom Wadewitz – JP Morgan
On the productivity opportunities you tend to run with a lot of different, I usually think you guys have a full productivity pipeline, and I’m wondering if Hunter maybe you could highlight some of the biggest productivity drivers and what the timing might be for when we would see an impact from some of those things in 2008, 2009?
E. Hunter Harrison
I think three areas I’ll mention on a short term basis and one of a longer term nature. One is by year end we will have the new yard at Memphis fully implemented.
We will, I think within the next tw0 months we will be [inaudible] cars there which will have a nice positive impact on terminal expense that we talked about earlier at Battle Creek. It [inaudible] Chicago, Steven Point, so that’s one initiative.
The continuing initiative in taking advantage of the long siding program which is near completion, it’ s probably 85% done, but it’s just now fully kicking in, that’s another one I would mention. There is a lot of them going on in mechanical and smaller, but the largest one is clearly where we’re spending a lot of time and resources is with EJ&E transaction in Chicago.
I think the more we talk about and the more we learn and the more we look at that transaction, it offers every day I see more upside opportunity than we initially saw in the transaction. So, Tom that’s just an example of two or three things.
Tom Wadewitz – JP Morgan
On the Memphis and the long siding where would that tend to show up in the P&L? Is that a headcount where that would show up or equipment rents?
E. Hunter Harrison
It wouldn’t show up in equipment rents, it shows up basically in line of productivity predominantly the most of it. I’m not a headcount person, I’m more of an expense person, I don’t get sensitive to headcount when I see expenses down.
So we’ve contracted in a lot of engineering work that we were doing our self which was one of the reasons, I think that we developed a relationship that we were able to get an agreement quickly with the steel workers, and get 80% ratification for it. And then we talked about the replenishing of the predominantly older workforce and the overlap when we do the training, so that will wash itself.
So that’s where those two things and that’s just two of many. We’ve gotten new locomotives and we’re starting to see the opportunity with the fuel productivity with the locomotive that will get better.
And, to some degree it’s just to take advantage of those opportunities when you look out here at 35 degree weather in Western Canada, 35 below in Western Canada and your having to run to adjust to the weather. But I can tell you this, as I said earlier, since we got the little setback with 2007, with those issues that I mentioned.
We’re back where we were prior to that and I think you’ll see the productivity metrics make a pretty substantial move forward.
Operator
The next question comes from Edward Wolfe from Bear Stearns
Edward Wolfe – Bear Stearns
Could you talk a little bit about pricing? I know Jim talked about going forward 4 to 5% pricing, but if I look at the reported yields for the quarter on a mixed adjusted basis, down 6%, can you talk about what there is to FX?
What’s fuel? What’s pricing?
What’s mixed?
James M. Foote
Well if you look at the quarter’s result and you adjust the volumes for this significant pickup in iron ore, our volumes in the quarter were relatively flat. Which I believe, if you look at the other business groups with forest products being down as much as it was, the other businesses did very well.
Then you add to that the prices impact in the quarter you’ll see that the prices are pretty much in line with what we have been talking about in the past of around 4%. Going forward into 08 we expect that trend to continue and would be slightly higher than 4% between 4 and 5 in 08.
Edward Wolfe – Bear Stearns
What makes you confident it’s gonna be higher? What areas?
James M. Foote
Our pricing is pretty much consistent from business unit to business unit. And, what makes me confident that pricing in 08 is going to be good is because most of our contracts, number one are two to three years in duration, so I have anywhere between 66 and a third of our business is already priced for next year, and that is in the range that we’ve talked about in the past 3 to 4%.
Those prices are already locked in for 08 and the price that I am getting on my current contracts is higher than that.
Edward Wolfe – Bear Stearns
Are there any significant long term legacy contracts coming up?
James M. Foote
No we don’t have any long term legacy contracts. All our business, as I say is contracts for about two to three years and therefore we have been pricing in these ranges for the last five to six years and steadily improving on our price tick, which has been reflected in our yield numbers in the past.
Edward Wolfe – Bear Stearns
So we have 4%, let’s call it pricing in the quarter, lets reset the volume to zero based on your discussion, what takes us to minus three in revenues from there? Can you take me through the fuels are positive, mix is a negative and FX is negative and how we get from positive four to negative three.
James M. Foote
Well the reported fourth quarter revenue number was zero. So the impact is extreme, so that’s the difference.
Edward Wolfe – Bear Stearns
I’m guessing that there’s some year-over-year fuel positive based on how much surcharges are and so forth right?
James M. Foote
That’s correct, there would be a positive impact in the quarter from price, there would be a positive impact in the quarter from fuel.
Edward Wolfe – Bear Stearns
Is fuel part of that 4% or is that separate?
James M. Foote
No that would be separate from that.
Claude Mongeau
What you have to recognize Ed, is that the fuel is not as large as you would expect because there is a two month lag in our fuel surcharge. So in effect, I think, the fuel surcharge WTI price during the quarter was no where near the $91 spot price that we paid for our expense.
Year-over-year fuel surcharge us up slightly, prices in line with what Jim is discussing and the volume was up slightly.
James M. Foote
We had 4% price, 1 to 2% for fuel and 1% for volume.
Edward Wolfe – Bear Stearns
Can you talk a little about Prince Rupert in terms of numbers? In the past you’ve talked about a run rate of $100 million for 08, are you online for that?
And, what could take you above that in terms of having other boats besides Costco? Where are you in those negotiations?
James M. Foote
Yes I think Bob has given some guidance there in terms of that number and that would certainly be the number that we’re expecting in 08. Upside to that would be two factors: one, would be having another customer make that a protocol and we’re continuing to dialog with all the major steamship companies as well as their customers about calling there and are optimistic that we will have another customer make that call.
As well as the outlook for the existing customer consortium which is Costco, Hang Jin and Yang Ming who are all on the vessel rotation to increase their volumes and we are in dialogue with them about them potentially doing that as well. So, either one of those scenarios will bring our outlook for the year up.
Edward Wolfe – Bear Stearns
What are you seeing on exports back through Prince Rupert? Any business yet?
Still in the backhaul?
James M. Foote
Yes, in various different commodities, that the backhaul opportunities that we’ve talked to, ranging from machinery to paper products to [inaudible], working with a number of different customers today on non-traditional bulk products that have the potential to move via container. So we’re working hard there and working Costco and those opportunities are coming on.
Edward Wolfe – Bear Stearns
Okay, this last follow up on that. Does that $100 million include backhaul or is that gravy if that develops?
James M. Foote
That would be gravy, but again I’m not confident enough or foolish enough to say that I’m gonna be 100% balanced from backhaul. This backhaul business is gonna take us a while for us to develop.
We’re in the process right now of just building a facility in Chicago where we can fill containers with the derivative products from the ethanol productions. We have a signed some arrangements with customers to bring products in there but again that’s probably going to be 10% of the ethanol volume filled throughout 2008.
Operator
Your next question comes from Randy Cousins from BMO Capitals Market.
Randy Cousins – BMO Capital Market
In the context of your guidance do you see earnings growth evenly spread over the year? Or are you betting on recovery in volume in the second half and a slow start to the year.
Claude Mongeau
If your question is the EPS outlook and how it shapes up by quarter? The first quarter, you have to recall last year, is when we had the labor disruption, so we’re gonna have an easy comparison in the first quarter, and then after that we are seeing the business basically, back end should be better because we are expecting the economy to come out of the slump that we are seeing in some of the sectors in terms of weakness.
But some of the initiative, the growth of Rupert, the bulk business, all of that is stuff that we can deliver in the front end of the year because it’s in front of us, we just have to be fluid and run the railroad.
Randy Cousins – BMO Capital Market
Your guidance don’t require sort of recovery in economic activity in the second half to get your numbers, it just a case of executing on the business plan?
Claude Mongeau
I would say we do assume that the back end, when the economy will rebound. But in terms of our EPS the first quarter is an easy comparison and we have initiative that could grow throughout every quarter.
Randy Cousins – BMO Capital Market
My second question has to do with equity linked compensation. Can you give us a sense, is that tied to a US dollar calculation or is it the Canadian dollar and do how does it work?
What’s the sensitivity? So if CN stock goes up $1 a share Canadian how should we budget the equity linked compensation adjustments?
Claude Mongeau
Randy, I would have to give you the model on the basis of all of those factors. It is quite difficult to give you a rule of thumb because it does indeed depend on the Canadian dollar stock price or the US dollar stock price but by and large you’re not too wrong if you assume that $1 increase in the stock price would give you about $6 or $7 million dollars in expense.
Randy Cousins – BMO Capital Market
Finally, just with reference to the fourth quarter, so I can get it straight. Can you repeat the numbers that you stated in terms of comp adjustment down versus bonuses versus the equity linked component?
Claude Mongeau
We answered that for the full year, now you want it for the quarter?
Randy Cousins – BMO Capital Market
Yeah, because it was in the fourth quarter that you had the big change in labor expense line.
Claude Mongeau
Let me put it to you this way, our expenses on a year-over-year basis in labor were down $134 million. I would say that the stock base compensation and the fact that we did not accrue for a bonus in the fourth quarter would explain about 110 of that so that gives you an order of magnitude.
Operator
Your next question comes from Cherilyn Radbourne from Scotia Capital.
Cherilyn Radbourne – Scotia Capital
I wonder if you could comment on the EJ&E and just give us any idea how optimistic you are that you’ll be able to expedite that environmental review relative to the time line that was outlined by the FTB?
E. Hunter Harrison
Well, I’m not sure that they defined the timeline of the environmental review. I think they made, in my view, an error when they stated in the press release that it could take two to three years.
I think that’s a little ridiculous, in my view. If you go back to the past deals, I think the Conrail deal which that involved many, many states, seventeen states, and zillions of crossings and we’re talking about Chicago.
I don’t think that the environmental review will be that long. Now what is long?
I would hope that within a year from when these activities were started we could get some time of response in that regards. I think overall, I think from an economic standpoint, from a competitive standpoint, I think there’s virtually no problems with the transaction.
I know a few people that are opponents of it. So our issue is clearly going be when you cut through the environmental, it’s effectively a crossing issue in the western suburbs of Chicago, around the western parameters.
If you look of the total traffic in the greater Chicago area, they’ll be fewer trains across crossings, and if you look at the overall environmental impact, clearly for the greater Chicago area there will be a significant improvement. Now if it’s going be for others to deal with and we will fight the good fight here, trying to decide that trains shouldn’t move out of the inner city away from McCormick Place, away from Soldier Field, away from Cominsky Park, away from the interstate that is not much better and more efficient in that capacity is to go around the parameters of Chicago.
So I guess overall I’m optimistic, I don’t want to put any number of percentages on it. I think the transaction will be approved.
I do think that there could be an issue with the link that could cause us problem, or there could be an issue if somebody says we got to spend a lot of money to mitigate some of the circumstances that we would have to review that very carefully.
Cherilyn Radbourne – Scotia Capital
Claude I wonder if you could speak about the dollar impact of the inherent lag in your fuel surcharge program would have had on your bottom line in Q4? Is that something you can quantify?
Claude Mongeau
Yes, roughly speaking the sum exchange we do disclose is about $0.05 during the quarter. And, the fuel lag is I would say is in the range of $25 million in the fourth quarter.
That is basically paying a higher fuel price on higher spot price that our fuel surcharge because of the two month lag.
Operator
Your next question comes from Scott Flower from Bank of America Securities
Scott Flower – Bank of America Securities
I guess one clarification for Claude, and I know you have several questions already, but in my own mind on the labor and compensation side. In terms of the incentive comps, is the lack of bonuses or the accrual is that just a fourth quarter phenomenon or did you actually reverse accruals for prior parts of the year in terms how fourth quarter was versus what total your bogies were?
Or was it just fourth quarter phenomenon?
Claude Mongeau
We adjust our accrual throughout the year. Butm in the fourth quarter there was no reversal for prior quarters.
Scott Flower – Bank of America Securities
There wasn’t a true up for quarters one through three.
Claude Mongeau
No, it’s just the fact that we didn’t.
Scott Flower – Bank of America Securities
The other question I had, maybe for Jim was just, and you’ve answered a lot a questions already obviously on the top line side, but you mentioned obviously the one paper producer in Eastern Canada, and I don’t know what caused that, but I’m just wondering are you seeing any lag impact from the much stronger Canadian dollar? Because a lot of time goods and trade will see an impact on a lag basis to what was a sharp change in currency exchange rates.
And, I’m just wondering when you look at your book of business are you seeing some lag impact on your volumes, and I’m assuming would be one of those that are affecting your volume outlook?
James M. Foote
I think issue with paper is clearly our paper customers in Eastern Canada are clearly impacted by the dollar. But, its more to do with the overall decline in the market for paper which has put them under pressure now for quite some time.
And, so in a very difficult business market to begin with, really not associated with the economy for the dollar to have come along and appreciated at this point and time has made it difficult for them and there has been a productions cutback and curtailment in many locations, by many producers in an attempt for them to adapt to the declining market. Some of those production cutbacks have been positive for us, and some of them have been negative for us.
From a dollar perspective that is about the only area at this point in time where I can point to and say, where any of my customers are having difficulties from the dollar. The lumber and panel decline is associated with the housing issues not the dollar.
On the other hand, I have an outlook for the movement of iron ore right now because US steel manufacturers have looked at raising their production output because of the lower US dollar, which is making US manufactured products much more competitive globally. So my outlook right now is very optimistic and is not dampened in any way shape or form by the dollar.
Operator
The next question comes from Jacob Bout from CIBC World Markets
Jacob Bout – CIBC World Markets
Just a follow up on that last question, maybe you can just comment on the flow of traffic within North American as a result of the Canadian dollar strengthening but more on the US weakening and be more active in the export market and some of the volume that is New Orleans.
James M. Foote
Well, if you take a look at the business opportunities that we’ve talked about, to only this quarter but in the past we’ve worked very aggressively to make sure that our company was positioned and not reliant on one specific market. And so the opportunities that we’re talking about are clearly not dependent upon the strength of the US economy or the exchange rate, Canada and the US.
Western Canadian shipments to offshore, sulfur equipments to offshore, potash movements from Canada to the US driven clearly by record fuel price and a 25% increase in corn production. As I just mentioned iron ore volumes moving into the US because of the lower US dollar, so our traffic flows are very diversified, are very dependent not only one commodity but, not dependent upon any one regional commodity or economy.
So I’m very optimistic when I look at my portfolio of business and I see my intermodal business on the West Coast increasing, not only at the new port but in Vancouver where the predominance of that is coming into the Canadian market that I am realistically comfortable that we will not feel the impact maybe as much as some other railroads might.
Jacob Bout – CIBC World Markets
The second question, as far as the FTB ruling on the new real cost formula for regulated freight, how big of a concern is that internally in looking forward? Is there any concern about that going over into non-regulated freight?
Claude Mongeau
We don’t obviously agree with the exact calculation and where they came out in terms of the cost of capital. We think our cost of capital you should be a better judge of that is actually higher than where they came out.
But I think the impact is going be bagged and at the end of the day I think people recognize that whether it’s in Canada or the US we are in a world where there’s the back of infrastructure and if railroad as a private structure basis are going to extend to build up that infrastructure we need to make a return.
Operator
The next question comes from Bill Mackenzie form TD Newcrest
Bill Mackenzie – TD Newcrest
I was wondering if you could talk a little bit about your service levels and if you take a look back at 2007 how you feel you did from a service perspectives with your customers? If you have any metrics you might be able to share in terms of on time originations or just general customer service and satisfaction levels?
And, are there any particular end markets that you’re really focusing on for 2008?
E. Hunter Harrison
I think overall our service was very good, we measure internally, we use to talk about it a lot, but we still measure each one of our non booked carloads has a trip plan, it’s measured by hours, not days and overall we did very well. Now clearly during the weather problems of the first quarter and the work stoppage you might say that service was not up to our normal level, but after we came out of the work stoppage and through the second, third, fourth quarter until we reached the point here with the weather in the first of the year as a result of the freezing weather, our service has been very good.
The issue that you have with service is this, is you have a problem defining what’s good service. I’m trying to learn a new phenomenon in Canada, when they talk about service, they talk about you have bad service when you raise price, so you’ve got to define service.
Our transit time, the condition of our equipment, the timeliness of our switching, the investments we’ve made in new equipments in capital, our switching is far better than any of the competition in our view.
Bill Mackenzie – TD Newcrest
Jim maybe to get into forest products a little bit more for 2008, been hearing about more facility closures. Just wondering if you have a volume expectation for forest products on an RTM or carload basis for 08.
James M. Foote
Where are right now I would think that we would see in the forest products business unit at down 3 to 4% in terms of carloads for the full year, is kind of where we expect to be. After this year where we’re down 13% or so for the group, so obviously starting to, as I said earlier, bottom out in terms of some run rates here and hope that we see some optimism as we move closer to the end of the year.
Bill Mackenzie – TD Newcrest
One last questions, Claude, in terms of the balance sheet you guys have been pretty aggressive about buying back stocks, you’ve been spending more money that what you forecasted for free cash flow for next year. I’m just wondering how sustainable is the current buyback activity and if they’re any particular debt threshold that if you were to hit would result in you guys getting a little less aggressive from the buy back perspective?
Claude Mongeau
Actually we’ve been quite consistent in our approach, we adjust as we go based on our performance against strategic agenda. But effectively what we have said is that we are gonna focus on a coverage ratio and we have an ability to lever up which we have during 2007 to some extent but we are still in process of doing that levering up to a point where we target 2.2 times EBITDA coverage as a target going forward.
I think we finished the year just under 2.
Operator
The next question comes from David Newman from National Bank Financial.
David Newman – National Bank Financial
Just on the buyback, in terms of your guidance what do you presume in the second half? Are you gonna keep it at the elevated level or should we have it going back down to the say 5%?
Claude Mongeau
Actually the current program for the 33 million share. I think at year end we were basically a little bit past the midway with something like 17.8 or 17.7 million shares that have been purchased.
I think, barring unforeseen circumstances it’s our expectations that we will complete the program between now and next July.
David Newman – National Bank Financial
In July Claude would you continue on at the 33 million rate or would you step it back down to let say a 5% buy back again? In other words, what have you presumed in your guidance in terms of the bottom line guidance, have you presumed as of July of next year in 08 that you’d move back down to the 5% level?
Or are you considering discontinuing the current levels?
Claude Mongeau
We’ll reserve our judgment in terms of that decision when we make it with our Board in the spring to early summer timeframe. But I would say to you that effectively the first six months of buyback really tells the story in terms of the year-over-year impact.
And it’s our expectation at this point that our use of free cash flow will go towards share buyback. And, without putting the pinhead on exactly how many share we expect to be buying back in the second half of 2008 as well as the first half.
David Newman – National Bank Financial
Do you have any discretion on the program that you can come in today’s markets at these levels and buy back more than let’s say a dollar cost average?
Claude Mongeau
Well, we tend to be buying back on an ongoing basis, but we are opportunistic and clearly when we see the stock price coming down we modulate accordingly. But, we’re buying throughout the year within the guidelines on what is available to us on a slow basis particularly when we’re buying in the US market.
David Newman – National Bank Financial
Switching gears, over to Rupert. Jim, I’ve heard rumors that there’s some pilotage or tugboat costs that might be a little higher than let’s say on the US ports, or even Vancouver.
Obviously US ports have raised a lot of costs as well, how do you benchmark against the US guys? Tacoma?
Seattle? Long Beach?
Is Rupert at a competitive advantage on the cost at port?
James M. Foote
Yes. The port there is very productive and competitive.
Andm from a complete logistic chain significantly of better service and lower cost than the other West Coast port.
David Newman – National Bank Financial
Last one, Jim did you say that you’ve locked in about two thirds of the price increase for next year?
James M. Foote
That would be correct. The way our contracts are structured, if they have a three year contract that I signed it has already been priced.
David Newman – National Bank Financial
Last one Hunter, on the [Jay] do you think you might have to put more cap ex into the situation than you first envisioned to sort of apease the local residents?
E. Hunter Harrison
I think that’s a possibility realisticly. To some degree, we have a little leway with the $100 million that we said when we purchased it.
We have talked to every community, or just about every community that going to be affected by this that had issues and we have encouraged them to have a dialogue with us. We’re prepared to do the right thing, but there’s a limit.
So could there be a case where we have to spend X amount more to help that situation and help it in more ways than one. For example, rate separation there’s formulas not that says how much is paid by states, how much is paid by the feds, how much is paid by the railroads, and if there are separations that’s a separate situation, but yeah we’re prepared to step up and if we need to spend a little more capital to relieve some of those situation.
We’d be happy to take it under advisement.
David Newman – National Bank Financial
Material or would it be within your $1.5 billion in budget?
Claude Mongeau
I think it’s fair to say it would be a 2009 and 2010 expense. Because quite frankly just the planning and the focus on getting the transaction approved will be what we have to do in 08 and then these expenses to the extent they are meaningful it would be 2009, 2010 timeframe.
Operator
You have time for one last question. The last question comes from Walter Spracklin from RBC Capital Markets.
Walter Spracklin – RBC Capital Markets
Just on the union contracts, Hunter, you’ve been pretty successful since first quarter last year in negotiating some union contracts. On the horizon 2008, can you give us color on the meaningful union contracts that you have coming up?
And are you finding that, given that you went the full all 10 rounds with the UTU and successfully came out of that, is that giving you a little bit more, call it leverage on those negotiations? Clearly they’re never easy to do, but are you finding the pushback or the negotiating process on a relative basis any easier?
E. Hunter Harrison
I think it’s fair to say, and I don’t want to leave anybody out, we’ve got a couple of very small numbers as far as number of people represented in 2008, it’s just handfuls. So effectively, with the steel workers, with the IBEW and with the UTU in the US, the big ones are out of our way until the end of 08 and that would be the Engineers that would be coming up.
Now we have a philosophy that says, “We’re not going to go to the negotiating table unless we have the ability to say no.” And I don’t think anybody should.
We want to be reasonable, we want to try to make fair deals, but if we’re faced with the same situation we were last time with the UTU, and I hope we don’t get that situation, we’re prepared to say no and we’re prepared to run the railroad. Having said that, I’m confident that we can come up with a settlement, and if not - I thought it was a little unfortunate in the whole process that we had the binding arbitration that was mandated to us by the government.
But they’ve basically set a pattern here, I mean if they give one organization 333 and status quo on everything else, that’s about all there is unless there is some negotiations on both sides and that’s fighting to a lot of people. So I think we’ve come a long way, our labor relations group has done a stellar job the last several years, particularly on the non op side of the shop and we’ll get there with the operating traps.
It’s a bigger change and it’s something that is more difficult to get done and I have to remind myself, with the first [inaudible] agreement in the US it took us nine years to get it ratified. So we have to be, and I am talking to myself when I say, a little patient.
I think most of the labor turmoil hopefully is behind us and everything will be going forward in a positive manner.
Walter Spracklin – RBC Capital Markets
To continue on the labor quote, you mentioned on the pension [inaudible] you’re going to get some relief in range of 60 to 65. Just wondering what your assumptions are for interest rates given we’ve seen a big 75 basis point cut today, equity markets are choppy, is there anything on the horizons in terms of top ups defined benefit pension plan in the event that you have to change your assumptions?
Claude Mongeau
Actually our expense for 2008 is set on the basis of the discount rate at December 31, 2007, so that one we know. And, we know that the expense benefit is actually a little bit more, it’s closer to $65 to $70 million dollars in terms of year-over-year decline.
Now next year’s discount rate, which will be set on December 31st of 2008 would have impact on our 2009 expenses. So that one is basically premature to try to judge where that’s going to go.
It’s a function of that discount rate, investment return and a bunch of other items which are too difficult to predict a year in advance.
Walter Spracklin – RBC Capital Markets
And you’ve given us some sensitivity in the past, I guess they still hold?
Claude Mongeau
Yes.
Walter Spracklin – RBC Capital Markets
Last question just on cap ex, you budgeted $1.6 million for 2007 came in at $1.387 and now you’re moving up to $1.5 million.
Claude Mongeau
Walter we always guide on a growth cap ex basis and net cap ex is after leases, capital leases which are basically non-cash cap ex so we have guided at $1.6 billion for 2007 and we did come in at around $1.6 billion, if I exclude the fourth the quarter impact of the capital lease for Central Station. And next year we are guiding to $1.5 billion on a growth basis and that includes the upgrade for the ANY.
Walter Spracklin – RBC Capital Markets
Did the decline that you’re budgeting compare to 2007 given, I presume that EJ&E is in there, you have your presumably higher revenue base and so on, is there anything that you decided not to go ahead with? Or any products that you’re scaling back on?
Or, is it just a function of being a little bit more targeted as you say?
Claude Mongeau
It’s the function of being targeted, but also a function of a number of the large scale project that has been a mainstay for CN over the last several years are coming to an end. I would give you as an example, our significant investments in siding extension we still have fill ins here or there, but we’re basically for the most part completed there.
So we’re targeting where it matters and we’re also sensitive to the general economic environment and so we think that’s gonna be sufficient to focus on what we have to do and as far as productivity and growth and a safer plant.
Operator
That concludes the question and answer session. Do you have any closing remarks Mr.
Harrison?
E. Hunter Harrison
Thanks for joining us and have a nice safe day.
Operator
This concludes today’s conference call. You may now disconnect.