Canadian Pacific Railway Ltd (NYSE:CP) Q2 2019 Earnings Conference Call July 16, 2019 9:30 AM ET

Company Participants

Maeghan Albiston – Assistant VP of IR

Keith Creel – President, CEO & Director

John Brooks – EVP & CMO

Nadeem Velani – EVP & CFO

Conference Call Participants

Christian Wetherbee – Citigroup

Walter Spracklin – RBC Capital Markets

Fadi Chamoun – BMO Capital Markets

Allison Landry – Crédit Suisse

Kenneth Hoexter – Bank of America Merrill Lynch

Thomas Wadewitz – UBS Investment Bank

Scott Group – Wolfe Research

Brian Ossenbeck – JPMorgan Chase & Co.

Seldon Clarke – Deutsche Bank

Benoit Poirier – Desjardins Securities

Ravi Shanker – Morgan Stanley

Operator

Good morning, my name is Adam, and I’ll be your conference operator today. At this time, I’d like to welcome everyone to the Canadian Pacific’s Second Quarter 2019 Conference Call. All slides accompanying today’s call are available at www.cpr.ca. [Operator Instructions]. I’d now like to introduce Maeghan Albiston, AVP, Investor Relations and Pensions, to begin the conference. Please go ahead.

Maeghan Albiston

Thank you, Adam. Good morning, everyone, and thank you for joining us today. Before we begin, I want to remind you that this presentation contains forward-looking information, and actual results may differ materially. The risks, uncertainties and other factors that could influence actual results are described on Slide 2 in the press release and in the MD&A that’s filed with Canadian and U.S. regulators. This presentation also contains non-GAAP measures, which are outlined on Slide 3. With me here today is Keith Creel, our President and Chief Executive Officer; Nadeem Velani, Executive Vice President and Chief Financial Officer; and John Brooks, Executive Vice President and Chief Marketing Officer. The formal remarks today will be followed by Q&A. [Operator Instructions].

It’s now my pleasure to introduce Mr. Keith Creel.

Keith Creel

Thanks, Maeghan. Good morning. Listen, the team and I are extremely proud to sit here this morning and represent our 13,000 strong CP family. We get to share and discuss the record-setting quarter for this company. When I say record-setting, it’s a mix of records. Second quarter records are all-time records. Records in OR revenue, EPS, all-time record for workload on GTMs on the network, train length records, train weight records, locomotive productivity records, fuel efficiency records, and most importantly, quarterly safety record when it comes to — we had a very challenging first quarter to bounce back. The way this company has bounced back to regain the momentum that sets us apart from the industries, most specifically in our train accident ratio, the way we run the railway safely every day, speaks to the commitment into the potential that this company represents.

An all-time record as well on personal injuries for the company. So certainly, the culture when it comes to safety is strong and getting stronger. Something we’re extremely, extremely focused on and proud of. Now this kind of performance demonstrates what a mature precision scheduled railroading company ran by the best team of railroaders in the industry can produce.

That said, we talk about the records, something even more encouraging. This pursuit of operational excellence is something that — I call it a journey, it’s not a destination. Maintaining a constant pursuit, a constant constructive tension in the organization even in the face of record volumes when we’re focused on making sure that we keep our assets rightsized at the peak to accommodate and to allow for any kind of softening or immediate demand that we might face as well as our normal seasonal demands that come out in July, this team is doing that. Within that quarter, taking out locomotives and taking out headcount that’s associated with those locomotives, reducing us down almost 10% in the locomotive fleet alone.

So with that being said, the quarter was not without these challenges. We talk about the things that went well. I can tell you this quarter we faced unprecedented pressures from the Mississippi River, much like our Class 1 partners. When I say pressures, the pressures did not let up the duration of the floods that we experienced this year. 40, 50 years, if you go back to history, you’re going to be hard-pressed to find anything that was that prolonged in the impact to this rail weight. And their team, I tell you, the men and women that run this railroad day in and day out are inspiring. They battled the floodwaters. They kept the railroad open as long as they possibly could. Yes, we had to reroute some. Yes, we had some additional operating expense tied to it, a little bit of capital expense tied to it and some foregoing revenue. But for us to be able to sustain that kind of pressure and bounce back the way we did, again, speaks to the testament of the strength of this team. Switch it over to the commercial side. I’d tell you we continue to make progress. That’s encouraging as well. We laid out a plan at our Investor Day in October.

We told the market, we told our shareholders, we told our investors that we had a unique set of opportunities that we worked hard to set up. We created a capacity and developed a strategic plan to convert it in the marketplace, and that is what’s fueling this pace of growth that’s unprecedented in the industry in a time where leader demand across the macro economy.

We call it self-help. We call it unique opportunities that allow us to be countered to what the balance of the industry is experiencing and that’s what you’re seeing in these results. You read about our press release during the quarter of Yang Ming, that’s one commercial success that John will talk about the specifics of it. And yes, we’re super excited about the partnership and absolutely excited about the revenue and what it’s going to do driving earnings and growth in 2020 and beyond. But from an operational perspective, I’m equally as excited because what it allows this company to continue to do, setting itself apart from our competition, setting a new standard for service in our partnership. That’s specific, what I call the third leg of the alliance, which is Hapag-Lloyd Ocean Network Express and now will be in 2020, Yang Ming. Allows us to continue to fine-tune and create an industry-best service that will get you from Shanghai to Chicago with the lowest on-dock dwell time. It can’t be matched by our competition whether it’s U.S. West Coast or other Canadian alternatives into the Midwest markets with our fastest transit time in our shortest routes and our reliable capacity. It’s something that’s compelling in the marketplace, and it’s something that we’ll continue to make a strong difference in our operational ability to continue to drive margins and operational excellence within the organization.

To add benefit to that as well, you’ve probably read HME and Hyundai, which is a — it’s a customer that CP currently enjoys a partnership with. They made a strategic decision as well, effective spring of 2020, they’re joining the alliance. So that volume now currently calls them in term on the South Shore, which CP serves, that volume shift to Deltaport will be handled by our partners at GCT and will be moving on the shift with the alliance, which again gives us another step to incremental improvement, takes out complexity in the terminal, takes out additional costs and improves efficiency and velocity.

Just as a proof point, you think about this. If I go back 1.5 year ago, the share at GCT Deltaport is going down to about 20% for CP and the balance for our competitors. With this new contract, it comes online in January. We’re going to be about 65% to 70% of the product that’s been discharged on the dock at GCT.

Again, enabling that reliable service, industry-best service into the Midwest. So when you think about all these things, you put them together. What does it mean? What does it mean for our customers? What does it mean for our shareholders and our investors? It’s a solid proof point that when we say we’re going to do something, we do it. It says that sustainable profitable growth, it’s not just a catchphrase, it’s moving into the DNA of how we run this business. And when you do it and you do it well and you live and die and breathe by that principle, you do what you say you’re going to do, you don’t try to be everything to everyone but those that you serve, you serve the best. And you do it with this kind of culture and this kind of discipline. These results are possible.

And it allows you to grow this company now and into the future. And as excited as we are about 2019, the opportunities that John and the team put together for 2020 and 2021 from an investor standpoint, we certainly expect not only in ’19 to meet our guidance but to carry strength and momentum in the 2020 and 2021 as well. That’s going to bode well for anybody who’s invested in this company as well as our employees as well as our customers. The perfect trisection. With that, I’m going to turn it over to John to provide some more color on the commercial side and after Nadeem covers the financial performance, then we’ll open it up for questions.

John Brooks

All right. Thank you, Keith, and good morning, everyone. So total revenues were up 13% this quarter to $2 billion with 6 out of our 9 lines of business being up double digits in revenue. RTMs were up 6%. FX was a tailwind of 2%, and fuel was flat. On the pricing side, as expected, we continue to land in that 3% to 4% range. Now taking a closer look at our second quarter revenue performance on the next slide. I’ll speak to the results on a currency adjusted basis. So as Keith spoke to, it was an extremely strong quarter for the bulk portfolio. Grain was up 11%. Canadian grain and grain products delivered a record second quarter, up double digits. And both April and May were record months for volume, and from a tonnage perspective, this was the third-biggest quarter of all time for CP in grain. [Indiscernible] in Canada is now complete and as of right now we expect new crop to be in line with the past couple years.

Additionally, we project carryout stocks to be normal but certainly more heavily weighted on the canola side. All this to say, we expect there to be good volumes of grain to move this fall. As a reminder, the new regulated grain pricing for CP taking effect on August 1 will be 3.7%. But in contrast, U.S. grain volumes were down double digits as the P&W export market continued to be challenged due to the lingering trade dispute with China. We’re watching U.S. grain markets closely though because with the flooding and tough-growing conditions that have emerged across the Central and Eastern U.S. Actually this might present a pretty good opportunity for CP grains into these areas that are expected to be short production. Moving onto the coal business. As a result of maintenance outages at both port and mine. Canadian coal volumes decreased this quarter. However, in spite of the supply chain challenges in Canada, we actually saw fairly strong movements of thermal coal in the U.S., and our revenues were up 5%.

The demand environment for met coal remains strong, and we continue to expect a strong back half of the year. On the potash front. Q2 was an all-time record quarter for volume and revenue as strength in our export potash outweighed weakness on the domestic side. That weakness being the result of flooding and again poor weather condition in the upper Midwest in the United States.

But in spite of the weakness from the domestic side and certainly some tough comps we have coming into the second half for the year on potash. With strong global demand and still a very healthy pricing environment, we expect the opportunity for upside as we move into the second half of the year.

On the merchandise front. The energy, chemical and plastic portfolio had another strong quarter with revenue growth of 22%. The growth included another strong quarter of LPGs, plastics, refined products, all moving on our energy train in Vancouver. Excluding crude, ECP volumes were up 9% and revenues grew 13%. On the crude-by-rail, as expected, we came in at around 25,000 carloads or approximately 160,000 barrels per day as production curtailments began to ease and the fundamentals began to improve. Although, crude-by-rail remains a variable, we expect volumes will continue to increase as production and curtailment balance stabilizes, and our new contracts and existing customers continue to ramp up the second half of the year.

In MMC, volumes declined 9%, largely driven by a frac sand, however, revenues were only down 2%. Consistent with what I’ve spoken about a number of times in the past, we’re executing a surgical strategy to re-hone our frac sand from the Permian basin to the Bakken. This market diversity yields higher revenue per carload, single-line haul efficiencies and improved margins. We currently have 2 unit trains facilities in service, and we’re adding a third unit train facility in this region by the end of the year.

In automotive. Certainly, despite a weak North American demand environment, CP revenues were up 12% in the quarter. We continue to see success driven by GLOVIS and the opening and ramp-up of our Vancouver auto compound that we’ve spoken about. As a reminder, this is only a portion of the GLOVIS business with the full contract coming online to us in 2020.

This, combined with continued growth at Vancouver, gives us confidence in this sector well into next year. And finally, on the intermodal side of the business. Overall revenues were up about 11%. Both domestic and international volumes were up low double digits. In fact, despite some softening in the retail sector, domestic revenues were a record in Q2. On the international side of the business, we continued to excel in the market and execute our playbook.

Most recently, I’m very pleased that CP was named Best Logistics Provider in Rail at the Asian Freight Logistics and Supply Chain awards in Hong Kong. And further, as Keith mentioned, preparations are well underway with Yang Ming for 2020 onboarding of their volumes, which will move to GCT Deltaport, leveraging our capacity not only at the port of Vancouver but also at our capacity and our inland terminals across our network. We’re also excited, as is Yang Ming around taking a full advantage of our fastest route into Chicago, Toronto and Minneapolis. So look, I’m extremely pleased with the efforts of the team, sales and marketing team in collaboration with the operating team to deliver this quarter. So well, there’s no doubt, there’s uncertainty in the macro environment and some softness in some of our lines of business between the combination of our strong bulk franchise coupled with new business that is moving now and new business that will be starting up in 2020. I have a high degree of confidence that we will continue to deliver the growth and outpace the industry.

The CP team is focused, and we’re collaborating with our customers to create efficiencies and convert opportunities in the marketplace. With that, I’ll pass it over to Nadeem.

Nadeem Velani

Thanks, John, and good morning. As Keith noted, this was a strong quarter by virtually any length. When we reported in April, I was encouraged by how the volume and operating transfer were recovering from a challenging quarter — challenging winter. Those trends continued throughout the quarter and led to strong revenue growth, as John detailed, as well as very strong cost control. The end result was a Q2 operating ratio, decreased 580 basis points to second quarter OR of 58.4%. Ignoring the impact that last year’s labor disruptions had on the OR and Q2, we still saw an improvement of 440 basis points year-over-year.

Adjusting for land sales, depreciation and stock-based comp, we saw incremental margins of about 90%. Taking a closer look at a few items on the expense side. As usual, I’ll be speaking to the results on an exchange-adjusted basis. Comp and benefits was up 8% or $28 million versus last year. The primary drivers of the increase were increased stock-based compensation of $20 million, resulting from the higher share price as well as higher headcount.

Fuel expense was flat year-over-year as increase volumes were offset by decreased price and record Q2 fuel efficiency of 0.93 gallons per thousand GTMs. Materials and equipment rent expense were both flat year-over-year. As expected, depreciation was $183 million, an increase of 5%.

Purchased services was $265 million, a decrease of $23 million or 8%. Primary driver behind the decrease was a land sale of $17 million, which we guided to on our Q1 call, decrease ruin in stock cost and other operating efficiencies was a further tailwind. Additionally, the casualty line under the purchased services reverted back to historical levels. Rounding out the income statement. Adjusted income increased by 33% and adjusted EPS grew 36%.

Below the line, I’ll note that there was an $88 million income tax recovery related to changes in the Alberta corporate tax rate. This benefit was excluded from normalized earnings and will have a negligible impact to our 2019 expected tax rate. As the benefits are phased in over the four years, we will start seeing more meaningful benefits or effective tax rate.

Turning to the next slide. Our leverage in the quarter came in at 2.4x, adjusted net debt to adjusted EBITDA, within our target range of 2x to 2.5x. In May we repaid our debt maturity, which we refinanced early in March with the strong operating performance and growth in the last 2 years, we worked our way back into our target leverage range. While CapEx increased sequentially given winter, flooding and network investments, we will keep our capital spending within our guidance of $1.6 billion.

We continue to take a balanced approach to shareholder returns. In May, we meaningfully increased our dividend by 27.5%. This marks the fourth straight year we have raised our dividend as we gradually move towards our targeted payout ratio of 25% to 30%. On the share buyback front. As of the end of Q2, we have completed nearly 70% of our current share repurchase program at an average cost of roughly $272 per share.

We will remain opportunistic and disciplined in our deployment of capital. Combining this discipline with our strong operating performance, we delivered an ROIC of 16.8% the last 12 months. This will undoubtedly be the strongest ROIC in the entire industry through the tremendous achievement by the CP team. The railroad is operating as well as I’ve ever seen it, and our team at railroaders is getting stronger and deeper each day. We continue to watch the demand environment closely and should the macro environment change, we’ll continue to adapt our cost base quickly. As Keith mentioned, we are confident in our full year guidance to expect to deliver another set of strong results when we speak again in October. With that, I’ll turn it back to Keith to wrap things up.

Keith Creel

Thanks Nadeem, John. Just to wrap up, looking forward to lots been made about our tough comp in the back half of the year. The tough comps are what happen when a company performs the realist, we’re going to stay humble, we’re going to stay focused. We understand the main environment is not without its challenges, but you can be rest assured this team is going to be focused, disciplined and committed and confident, delivering our guidance for the year. These results are a testament to the prior of our operating model and CP’s ability to execute operationally, financially and commercially, all at the same time. With that being said, let’s open it up for questions.

Question-and-Answer Session

Operator

[Operator Instructions]. And your first question comes from Chris Wetherbee of Citi.

Christian Wetherbee

Maybe wanted just to pick up on that comment about the second half and the comps that you guys faced. If you could talk a little bit about some of the key priority [ph] groups that you feel most confident about in terms of maintaining the mid-single-digit RTM growth as you face some of those tougher comps? And If there is some sort of demand, a sluggishness, maybe what are the areas where potentially you could see that kind of flow through? Just kind of curious about what your outlook is there on the volume side?

John Brooks

Chris, I can start off. This is John. Look, we turned in a really strong Q2 in the bulk side of the business, and I see that tailwind continuing. I am — as I mentioned, we’re kind of in the grain trough a little bit right now in July but I expect upside as we move through the quarter in the grain. The potash demand environment continues to be strong. We’re certainly — some weakness in the domestic side but we think that picks up through the quarter, and the export side continues to be very strong.

Tech is, for the most part, sold out Q2, Q3. So continue to see some tailwind there. Our year-over-year comp sales results to international intermodal. We still have, I think, some upside as I look through Q3 in that space, sort of, despite some of the challenge that others are facing. We haven’t seen the blank sailings with our customers in that area. So I’m a positive on all that space. I think we’ve outmatched the industry on the auto sector here now for the second straight quarter. And frankly, I think that trend continues as we move in to Q3 also. And then the crude side, in the assets, it’s a variable. And there is certainly some moving parts that need to be worked out here. But the contracts are in place. And we’re actually, I think, more optimistic today than we have been that these issues are going to get resolved. And this could be significant upside improved by rail.

Christian Wetherbee

Okay. That’s very helpful. No doubt. Last quarter, Nadeem, I think you were pretty constructive about your — the potential for the OR in the second half of the year even facing the more challenging comps that you had in here in Q2. Could you speak a little bit to sort of how you’re feeling after getting the second quarter done? Obviously, really strong performance. You mentioned very high incremental margins. It doesn’t appear that there was anything, sort of, blocking that as we move into the back half of the year. But if you could put some color around that, that would be great.

Keith Creel

Let me set this up for Nadeem. We’re still convicted Chris but over to you Nadeem.

Nadeem Velani

Yes, I think, Chris, I mean we’re doing what we said we’re going to do. As Keith noted, that’s — our conviction comes from that, comes from a network that’s running as we mentioned as good as we’ve ever seen it. It comes from that within our DNA of strong cost control and not getting involved in a false sense of confidence. But in times like this, we see a bit of softness you can start putting asset aside proactively and only adding resources where necessary. So same level of conviction in the back half. Yes, we had some tough comps, but we feel very good about what we can do from our cost-control point of view. And those incremental margins will add to the bottom line.

John Brooks

The fundamental demands, Chris, that drove the performance of second half of last year exists. The second half of this year was even more pent up demand, so to speak and an ability for us to execute, given our investments. Think about the grain fleet alone, we talked about investing in our hopper fleet. The efficiencies we get from that. We’ll just start to begin to realize some of those operational efficiencies. Meaning, fewer bad orders. Meaning, more velocity with the fleet. Meaning, I don’t need as many cars, I’m using the same more remote room with fewer cars. We’re looking at doing things with are potash fleet to respond to surging demand or record demand with our customers and partner in Canpotex, run a 200 car, potash trains to Vancouver and even to a point we’re testing with UP over Portland, we ran 188 car train, just recently. So we’re going to continue to push the envelope, squeezing what we can of our assets to do more with less, all within the mantra of precision-scheduled railroading as we continue to deliver service. And as we do that, costs come down, capacity increases, velocity improves. It’s just the different space to operate in with the same or better demand in the second half. You should expect better performance, which is exactly what this team is focused on producing.

Operator

Your next question comes from Walter Spracklin of RBC Capital Markets.

Walter Spracklin

I guess coming back to — Keith, your comments about how much more improved the handling is. The complexity is improved. And I look back at your — you know just eyeballing the last few years, going from second quarter to third quarter, you’ve done anywhere from obviously, some of the railroading in Canada is a lot easier, and you’ve done anything from 200 to 600 basis points quarters sequential. Nadeem, you talked about 100 basis points on the year is something that you generally target. But Gosh, everything you looking at, at here, given the items, Keith, that you mentioned it suggests that you could be well above the 100 to 200 improvement year-over-year on the OR. And then when we go into the next year with Yang Ming coming in and the lower complexity of everything consolidating at Deltaport. Again, my question I guess is are we beyond the 100 to 200 that we’ve typically come to expect in operating ratio improvement on the annual basis.

Keith Creel

Walter, I love your optimism and your belief in the model. Part of this art it’s possible, we exceed our expectation that have in the past but you’re talking about quantum leaps in areas that we make quantum leaps. And it’s just hard to keep setting a world-record model if we’re doing it every year. So we’re going to continue to improve. We’re going to sweat our assets, their puts and their takes, and we’re going to drive in spite of the headwinds that we face in these areas. We’re going to get incremental margin improvement for the next several years, given the business that I have seen on the railroad. And you could say, there’s some conservatism in our guidance. We feel we need to be responsible and guide to what we feel confident, that we’ll be able to deliver. But at the same time, I don’t want to be over exuberant and mislead and create a bar so high that we disappoint. That’s — I don’t want to demotivate my team either. But rest assured, you got a team here, you got a leader — a leadership team that will push this envelope in a responsible constructive way. And we expect and we hope to exceed your expectations.

But I can’t tell you that I see 200 basis points of opportunities given all the moving parts that we see out there and all the things that may or may not happen with winter. But I bet you case, when everything goes our way, a euphoric case, I’d love to be able to control it but I can’t. So I’ve got to be reasonable. I’ve got to be responsible in what my guidance is. And I see it confident and the ability to get that 100 basis points, but I’m not willing to expand this to the 200 not yet. I want to wait and make it happen instead of assume that’s going to happen. I just don’t think that’s a responsible way to handle it.

Nadeem Velani

The stock-based comps is probably the biggest headwind in terms of — so it’s a first class problem and certainly something that our shareholders won’t complain about in terms of bad headwind. But that adds a bit of a challenge when looking at year-over-year.

Walter Spracklin

Fair enough. And going down to the EPS level. I know your longer-term — your double digit for this — your longer-term double digit. Double digit is obviously a very unspecific wide range. Consensus is moving up now into that mid-teen — mid — might after this go into the mid-to high teen. Are you comfortable with that kind of progression? I mean you did 36% in the second quarter. Are you comfortable with that trend as you demonstrated very strong second quarter results that expectations go up into that mid-teen — mid-to-high teen range?

Nadeem Velani

I’d echo what Keith has conveyed on the OR side. I think it’s fair to — we want to be able to deliver on what we’re committed to. We’ve kind of talked about the double-digit, low double-digit type of range. Call it conservative or what have you. Just mindful of the things we can’t control, which is things that these curtailments, and if stock continues to run, that could be a headwind, and if you have some sort of weather description in December, what have you. So we’re mindful that there’s still a long way to go. We’re confident in our ability to grow double digits. I don’t want to get into that — the weaves of what level of double digits so I’ll just leave it at that.

Operator

Your next question comes from Fadi Chamoun of BMO.

Fadi Chamoun

John, you mentioned pricing in this 3% to 4% range. Is this pricing kind of a broad base? Are you seeing this strength across all the segment? I’m particularly curious about the intermodal market, the domestic intermodal market, we are seeing some easing in the freight-demand environment, I guess. And so if you can speak to that, please?

John Brooks

Yes. Fadi, so I was — we were talking earlier this morning. I’m quite pleased with the discipline the team has been able to show and the results we’re producing on the pricing front, really now going over the last year, quarter-by-quarter. So we landed in that upper end of that range again. And as I look at the renewal pushing into Q3, I think — I feel pretty confident that we’re going to be able to sustain that.

Certainly, as you called out, there’s some areas where there’s some weakness or little more challenged than others. We have seen, as you said, some weakness in the domestic sector, particular retail-type business. That being said, the pricing is held in there, also pretty decent, may be towards the lower end of that range specific for that area. I would also just call out, particularly for Q2, we did see some pretty positive mix 1.5 in that space. It had to do with some of our — less of our longer haul crudes, we had some shorter hall crude that took place that impact of that and then frankly, just some of our new business pricing has been quite strong that we’ve brought on this year.

Fadi Chamoun

Okay. Great color. The second question I had is, I mean, you feel very positive, obviously, about the opportunities to grow well into 2020, and you have few new business awards that you have already communicated. Is the CapEx outlook, kind of, continuing to be in that $1.6 billion range into 2020?

Do you see that creeping up? And as related to that, maybe to Nadeem, the free cash flow conversion like net income to free cash flow conversion has been just about 55% I think on average for the last few years. Can you talk about, kind of, the levers that you have as to kind of improve that as we move into the next 2 to 3 years. I understand there’s some improvement in the margin obviously, but is there anything else maybe on the CapEx side that is unique that you can highlight that could help improve cash flow performance.

Keith Creel

Okay. Fadi, if I can, I’ll take the capital question. I’ll let Nadeem expand on free cash flow. So when it comes to our capital envelope, the answer is no creeping. The same discipline in running the railways. It’s the same disciplined approach on managing capital. So as we talk about the formula, what’s the art of the possible? How do you get sustainable, low-cost growth. You create capacity. You sell to the strength of your network. You selling to the worth of capacity you have. And when you sign up new customers to grow the book revenue, you’re in lockstep with the capacity or the capital that’s required to create that capacity to be able to deliver the business. Because if you don’t, you jeopardize the entire operating model and success across every line of business. So the business that we signed up for ’20 and 2021, the assets we need be it in locomotive being remodeled, remanufactured. The surgical, starting here, starting there. CTC here there, CTC there. Inspection truck here, Inspection truck there. All that’s in the plan. It’s all phased into the plan. So you will not see a big swing in our capital envelope as we bring on this additional business in ’20 and 2021. And in fact after ’21 you’ll start to see our need for capital based on what we see today. Taking into account the growth, actually the diminishing comes down, not go up.

Nadeem Velani

A perfect segue to your second question about what we did, where we invested, where we continue to invest the opportunities right now on the covered hoppers, on locomotive monetization, or what we did with [indiscernible] and will do in Minneapolis as well to support our service, to support our growth agenda? Those things are trailing off. And I think the next leg of the story is going to be a very positive one from a free cash conversion point of view. So if you look in the — once we get past the investment covered hoppers in that ’20-’22 kind of timeframe, you’ll start seeing free cash conversion and more in the 75% to 80% kind of levels.

And so I think that, that is something that’s somewhat overlooked. And I think that’s going to be a very impactful story to CP in what we can deliver. So I think you’re right on in terms of what we can achieve and where there’s next opportunity.

Operator

Your next question comes from Allison Landry of Crédit Suisse.

Allison Landry

I just want to go back to the question on the RTM guidance and ask in a little bit of a different way. But if I’m just doing the math to get to, call it, 4% to 5% for the full year.

I mean basically on a sequential basis. Second half RTMs need to increase somewhere in the low double-digit range versus the first half. That’s a much bigger sequential increase than we’ve really seen historically. So maybe putting the tough year-over-year comps aside, how can we think about the sequential ramp-up for may be based on the commodities that you’ve talked about earlier in your response to, I think Chris asked the question, potash, grain, crude, et cetera.

Nadeem Velani

I mean, Allison, we’re up 2.7% year-to-date already. I don’t think we need double digits to get to mid-single digit. So I’m not…

Allison Landry

Sequentially, I meant. Not year-over-year.

Nadeem Velani

Sequentially, right. We use the back — the tough comps in the back half. So I’d point out to John’s comments on the strength in bulk areas, like potash. you’re going to see a ramp up in crude, which is going to support a strong sequential RTM growth so…

John Brooks

You’re going to see a pickup in tech, coal. I mean the coal itself, month-to-date. We’re talking about some of the softest we see. The growth that we experienced in the second quarter, Allison, was in spite of actually shipping less coal due to some supply chain challenges. It’s not a demand issue. It’s just working out some noises in the supply chain, which is working itself out. We’re realizing the third quarter. We’ve shipped month-to-date more than we did last year. So all those things with the 3% — 3.5% year-to-date number. The second half sequentially, you can be at a little bit north of the mid-single digit, and you’re going to come to the math that we’re coming to. Then it’s not hard to get there.

Allison Landry

Okay. All right. It sounds like you guys are pretty confident there. Keith, I think in your prepared remarks, you talked about, basically, hitting a record for workload in terms of GTMs on the networks. Where do you think you are from a capacity or resource standpoint, obviously, they’ve really strong incrementals in Q2. It seems like the network’s in great shape. But if volumes and workload growth persists, at what point might you need to layer back in some resources specifically on the headcount side?

Keith Creel

Well, the only place that we’re not capacity-constraint, we’re capacity-contained. We’re trying to be on lock stealth [ph] in locomotives. I mean we’ve said that all along. We’ve got more than adequate track capacity, terminal capacity. We’ve made some strategic investments in Calgary that we’ll realize this year into the fourth quarter. We just converted what was an old hump yard into a very productive switching yard, and we didn’t finish that until first week of January. So we haven’t even realized the benefit of that in the fourth quarter.

But again, locomotives, that’s it. We’re training, we’re hiring in large steps with our demand to make sure we’ve got the Running Trades employees ready to pull then operate the locomotives. And we’re bringing the locomotives online as we remanufacture them in large step with the demand as well.

So the game is not to be long on asset. We’ve got the right things, the right parts moving in the pipeline to be just on spot with assets. So when it comes to track and terminals, we’re not there at all. And in fact, our capacity, our flexibility, our ability to handle surges is drastically improved. We’ve got more capacity than we’ve ever had in partnership with GCT at Deltaport. Our South Shore is working extremely well. We’re hitting records with our grain partners there, creating capacity. It demonstrates the fluidity of the network. We’re talking about record volumes. We’ve put more stress on this network than has ever been put on this network in its history, in its 138-year history. And year-over-year, we increased train speed by 5%.

That just tells you there’s resiliency in this network. And if you’re an investor, you don’t need to get worried about this company getting into a trap, or we’re playing a catch-up capital gain, or we’re overcommitting. It’s a surgical execution of a strategic plan we developed two years ago in [indiscernible] in partnership with our customers. Protecting our customer service, protecting our investors’ trust and our employees’ trust. That’s what we’re doing day in and day out and that’s why we have so much conviction and confidence in our guidance.

Operator

And your next question comes from Ken Hoexter of Bank of America Merrill Lynch.

Kenneth Hoexter

Congrats on a solid quarter, Keith and team. Just the employees, how do you think about the trends as you grow and read costs. Should it stay mid — low mid-single digits with volumes, and your thoughts on the impact to the BOR with the employee base.

Keith Creel

Yes. On the employee base, like this year, mid-single-digit RTM is 1% to 2% headcount. We’re up a little bit right now with capital work at its peak. That will come down sequentially, and we’ll be that 1% or 2% on the mid-single-digit RTM. That’s the best way to gauge it.

Nadeem Velani

We were kind of pre-hiring and getting our people up in anticipation of the crude contract the Alberta government has started June — in July. So we’ve kind of pre-hired for that. So that was already in the cost base, as we speak.

Kenneth Hoexter

So you’re ahead on employees then because of that?

Nadeem Velani

Yes.

Kenneth Hoexter

Okay. And then my second one is on the crude-by-rail. Just given what you were just highlighting, Nadeem, on Alberta’s commitment and the shift to that potential. So I know that wasn’t in your commitment for volumes but maybe talk about what you expect to be the outcome, or what you’re seeing so far with negotiations? And where do you see crude-by-rail volumes trending going forward?

John Brooks

Yes. So you know what, I’m pleased with the progression of those discussions with the Alberta government. And we’re seeing a good expression of interest from a number of shippers in terms of commercializing, if that’s the right term, that capacity. There’s efforts underway with major producers in the government that try to find a workable solution. You’ve probably read about it, I’m sure, around the production levels matching curtailment. And if they can prove that, that’s going into a railcar, they would give that sort of equal relief.

So those discussions are ongoing. My guess, it’s probably at least another couple months, maybe more of a Q4 story if — in terms of resolution in getting ramped up. But all that being said, we did about 25,000 carloads in Q2. I can see that jumping up to 30,000 carloads with potential for upside as we look at Q3. So we’ve got a fairly steady ramp-up of stats coming online as we move forward here.

Keith Creel

Yes. I think the only thing I’d add, Ken, is listen, this is a space where [indiscernible], it’s been volatile, it’s been unpredictable. But I would agree with John, I’m cautiously optimistic, and I see the parts moving in a favorable direction for a favorable resolution. I mean the fundamentals are we’ve got a lot more oil being produced in the pipeline capacity to take it away. And there’s a demand forward in the market. We just got to work through this, and we’ll continue to work and lockstep with the government to get this issue resolved. And I think you’ll see fourth quarter in robust demand. It’s just going to be in the marketplace, which will represent some upside. If all other things work for us and all other things line up right and mother nature is good to us, then there’s a bit of optimism in the fourth quarter. But all those things had to happen. But again, there’s more force lining, acting against as far as trying to get this resolved in the crude space.

Operator

And your next question comes from Tom Wadewitz of UBS.

Thomas Wadewitz

Congratulations on a strong execution in the quarter. I wanted to ask you if you could give me kind of a high-level frame, perhaps, John or Keith, on share gains this year? And how you might — I don’t know if share gain’s the right term, but new business, let say? And what the revenue contribution is if you kind of put it together for this year? May be the high level on how we think about that in 2020? Whether that revenue contribution from new business would be larger or similar? Or just kind of some high-level frame on the new business impact?

John Brooks

I think it’s a good indication of, Tom, why you see what we’ve been able to do in Q2 and our confidence as we look into Q3 and Q4. We’ve got a — we’ve had a Dollarama. We’ve built an auto compound. We’ve seen significant upside with K+S as they continue to ramp up. Potash, the bulk remains strong and that, albeit, not new, but I think we’re performing well in terms of our share in those spaces also. We’ve talked, and I’ve talked quite a bit about wanting to further develop and grow our transload business.

I can tell you, we’ve had quite a bit of success as you look at in the Eastern markets with refined fuel, business going strong through transload. Our Hamilton steel facility has grown double digits in terms of that throughput. You start adding all those things up. I just looked the other day, we’ve added about $35 million of annualized new business with our short line partners so far this year. That’s sort of low hanging fruit that’s been out there for quite some time and you put a little focus to it. And that, sort of, singles and doubles start to adding up. So I think those are some of the things that are helping propel us today. As I look in the next year, in 2020, of course we’ve got the Yang Ming and the further auto opportunities that we’ve spoken about.

As GLOVIS hasn’t even fully ramped up yet. You got the G3 terminal opening up next year. We’ve got project for refined fuels with Suncor that we spoke about publicly that will start up next year. And again, you got — we forget about this business but K+S is really ramped up well. And they expect another big step function of growth as we look into 2020. You start putting all that into a blender and it becomes pretty compelling story.

Thomas Wadewitz

Well, let me ask you a little bit differently. So just do you think it’s a bigger impact this year in terms of the revenue contribution from new business or a bigger impact this year than next year? Is it kind of similar next year? Or how do you just frame the magnitude?

John Brooks

I think it frames the magnitude in mid-single-digit RTM growth and double-digit earnings confidence, Tom. That’s probably the best way to summarize it.

Thomas Wadewitz

And I guess the second one, just on — Keith, can you add a little more to your comment on Hyundai in terms of what that means if they are changing, and is there kind of new business for you on the volume side with Hyundai? Or that’s primarily efficiency or just maybe build a little bit on your comment that you started at beginning of the call.

Keith Creel

Yes. I think it’s both. I think it’s growth and volume for Hyundai. I think it’s also efficiencies. And I’ll say this and explain it. So they’re served us in turn. All the consolidation or the shipping industry over the last several years, where they landed with their partners, they weren’t benefited. They haven’t realized the same cost synergies that some of their competitors have. And although, we followed all of their business out of Vancouver, the size of the pie has been reduced because they’ve been at a cost disadvantage.

So move forward to 2020. They sign up with the alliance. They’re enjoying industry-best service. They’re going to enjoy industry-best cost. They won’t be at a disadvantage anymore. And we firmly believe that as a result of the cost advantage and the service improvements, they’re going to grow in the marketplace. And when their ships get fuller then our trains get fuller.

So it’s a quality revenue problem or opportunity for us at the same time. Any time we can take and [indiscernible] precision scheduled railroading, you minimize the moving parts, the remaining parts moving faster. The dwell on the dock is going to be lower. The trains are going to discharge larger and on time more frequently. It allows me to move my assets faster. My crew cost is going to be optimized. My equipment cost is going to be optimized, and my velocity is going to be optimized. It creates capacity, and it just hits you across every business unit incrementally because it’s moving in some of our highest density corridors. So it’s a positive, positive, positive. That I get just as excited operationally because not only does it allow us to enjoy the benefit now. It allows us to sustain constant improvement as we go forward and as we become better railroaders and as we get better. Through our investments and through our execution — executing operating model day in and day out. It’s a win-win, not just for intermodal but for CP and for all of our business lines that go through Vancouver, given it’s such a key corridor for this railway.

Operator

And your next question comes from Scott Group of Wolfe Research.

Scott Group

Nadeem, wanted to ask a follow-up on the guidance. Do you think that we maintained double-digit earnings growth in third and fourth quarter?

Nadeem Velani

Yes. I didn’t hear the last part. In what?

Scott Group

Do you think we maintained double-digit earnings growth in third and fourth quarter? I understand, full year, we don’t want to get into the double digit versus strong double digits. I’m just trying to isolate second half of the year.

Nadeem Velani

I certainly expect that, that’s a fair representation in Q3, Q4. It maybe a little bit difficult. I’m not going to give you a quarterly guidance on EPS but looking at what Q4 was — that was an all-time record EPS number for the company.

Scott Group

Okay. That make sense. And then, Keith, I don’t know if I’m a little early to ask this but I think the 10-year tech contract comes up next year. It’s the first time, sort of, this management team has an opportunity to take a look at that contract. Do you think there’s big opportunities, either from an operating or pricing, or just philosophically. Opportunities with that contracts since it’s been 10 years.

Keith Creel

It comes up in 2021. So you’re a little bit early, Scott but rest assured it’s not something that we’re not thinking about. Listen, here’s the strategy of this company. It’s our objective to become integral into the companies that we partner with. Their success, because when they do well we do well. We want to be part of their supply chains. We’re part of the reason that tech is able to enjoy reliability in the supply chain and lower-cost producers in market share and in real markets. We’re part of the following list. As long as we continue to play that role, we continue to be good supply chain partners. We originate the coal. We have access to Neptune. Access to Westshore.

We’re going to continue to be a key player, strategic player in — create compelling value that’s going to be hard to walk away. So when you talk about huge opportunities. To me the opportunity is to strengthen the partnership and help them grow in the market space, quantum leaps and productivity. Listen, we’re always going to push to move things better, and if we can knock out some of that noise, making the supply chain more a lability in partnership with the terminals at the coast as well as in partnership with the terminals that load the coal. And we do our part in the middle, then yes, there’s opportunities. But as far as quantum leaps, no; as far as improving and protecting that revenue stream and helping them succeed in the world marketplace I think we’re very confident in our ability to be able to do that. And that’s what gives us confidence at the negotiating table. We just got to make sense. When you make sense and you’re a partner with — it helps the company succeed in the marketplace. It’s hard to walk away from that.

Operator

And your next question comes from Brian Ossenbeck of JPMorgan.

Brian Ossenbeck

John, I just want to come back to your comment on the mix, crude, it’s been strong this quarter. Couple of points as you mentioned. Can you just elaborate a little bit on what’s was driving that? It sounded like crude was a significant source but also may be a mix of new business. So if you can elaborate on what do you expect to maintain that sort of clip in the back half of the year? And how much of that is reliant on continued ramp-up in crude?

John Brooks

Yes. So we definitely saw less long-haul crude in Kansas City, more shorter haul over some of our Western gateways and noise that had a material impact on some of the new business. And the crude-by-rail space that we brought on has also come on, as I mentioned, at very strong pricing level. Though I look at it like this, Brian. As I look at Q3 and Q4. I think that moderates — I’m not sure we see that mix tailwind like we had in Q2 at some of this other longer-haul crude ramps up backup.

Brian Ossenbeck

Okay. So crude is the biggest…

Keith Creel

It is.

Brian Ossenbeck

And just another question for you, John, on the Canadian EOP [ph] mandates now, and effective June 2021, a little bit later than expected. I think you’ve typically referred to that as sort of upside outside of the guidance but now it’s been delayed a bit, even past the 2020 outlook. Do you think actually having that in place will create any sort of shift as people start to get ready for that may be assessment that maybe actually means for the business whether we had something improved in spite of. Or is it still too early to think about any impact from that?

John Brooks

No. I think having that certainty in the marketplace now is that. We expect it to be somewhat of a capacity, sort of, crunch driver when it is applied. And now that we know, sort of, a locked in date, we can have those strength discussions on when we get into the renewals, and what our pricing looks like between now and then? And with the expectation that when ELDs do come about, how that’s going to change and impact the marketplace. So all in all, I think putting a line in the sand now and having clarity, actually that’s sort of helping us out.

Operator

Your next question comes from Seldon Clarke of Deutsche Bank.

Seldon Clarke

Just getting back to the outlook for margins in the back half of this year. You called that incremental margin of 90% in the quarter, which is well above your long-term.

Keith Creel

I wasn’t on.

Seldon Clarke

I’m sorry…

Keith Creel

Please take that if you can. You got locked on a little bit somehow.

Seldon Clarke

I apologize. So just wanted to ask about the outlook for margins in the back half of the year in a little bit of a different way. You called out incrementals of 90% in the quarter, which is, obviously, well above your kind of longer-term range of 65%. And you talked about pre-hiring employees and you had some tailwinds or mix in the quarters. So just kind of given all those moving pieces, how should we think about your core incremental margins in the back half of the year?

John Brooks

I mean when we guide the incremental margins, we talk about 70% or 75% level. We’re comfortable with that. I mean quarter-to-quarter, could it change? Could it be a little bit lower and a little bit higher? Yes, somewhat dependent on the mix business as well and just how things are operating. So I think, on the whole, we’re still confident with that 70% to 75% level.

Seldon Clarke

And okay. So even with the headwinds from the pre-hiring in the second quarter, you still expect that to kind of step down? And there’s enough — there are enough positives to get up to 90?

Nadeem Velani

I mean, yes. If you take up the pre-hiring, it will be closer to 100%. So that pre-hiring was done in Q2. That was in the numbers we just reported, right?

Seldon Clarke

Right. Yes. It’s kind of what I was asking why it was a step back down again or just…

John Brooks

Well, again, it depends on the quarter-to-quarter. There’s other cost and other things that vary between quarter-to-quarter, right? So if you hit 100% one quarter, doesn’t mean it’s going to be sustainable forever. So that’s why we guide on a full year basis, not quarterly.

Seldon Clarke

Got it. Okay. And then just kind of a longer-term question on OR. Just given everything that’s going on in the industry as well as the PSR, it feels like the theoretical for that management team is they’re willing to put out their kind of high 50s for OR. But just given like what you guys have done last several quarters. Your incremental margins are at 90% range and your quarter incremental margins at 70% to 75%. What do you think the ultimate floor is for rail ORs over the next several years?

Keith Creel

I’d say this, I’m going to speak to what — I’ve got good line of sight to and what I know, and obviously, I can’t control it all and some things get be a little shorter or actually overachieved. But I see an ability annually to improve with our business mix and the growth if we’re going to bring it online with cheer and with partnerships, organic and inorganic growth, appointing year for the next 2 to 3 years. So I’ll say this going annually from sub- 60 part of the possible mid-60s

Operator

And your next question comes from Ben Poirier from Desjardins Capital.

Benoit Poirier

Congratulations for the good quarter. John, just in terms of forest product. Obviously, a very good performance when we look at the revenues up 8%. It seemed a big discrepancy versus the industry. Could you maybe talk about what are the key drivers here in terms of forest product? And what you see kind of for the second half?

John Brooks

Yes. You know what, we’ve actually seen quite a bit of success in 2 areas. One is our pulp business has been quite strong. So that’s sort of a derivative of our growth in our international business that has allowed us to grow the pulp business for export back out of Canada. So we’ve seen good success in that space, and then our team has been focused really on asset utilization of our center beam fleet. So the lumber market has no doubt been challenged. But I think we’ve targeted into the market places that we do see sustainable business. And then really focus on asset utilization with our partners into those marketplaces. It is no doubt, as I look into Q3 and Q4, there’s going to be some headwinds in that space certainly as we got the sawmill curtailment that are somewhat ongoing in B.C. The good thing is that has less impact on us than and frankly because big part of our network in the West is transload origin transload, it gives us — we’ve actually got a bit of insulation from some of that impact. So I do expect that Q3 and Q4 in the forest product space will certainly be more challenged in the lumber space. But we’ll certainly going to try to sustain it as we look at into our pulp business.

Benoit Poirier

Okay. That’s great color. And may be a high-level question for Keith. When we look at the strength of the Canadian dollar, obviously, right now it’s 130. Still in line with the guidance — your assumption for the year so no material impact on the bottom line but does it influence the way some of your customer think about their business strategy? And is there a certain level where the Canadian companies could become, let’s say, having more difficulty or more competitive issues, Keith?

Keith Creel

It’s the same fundamental that exists. A lower Canadian dollar generally is going to favor the Canadian producer because it gives them a little bit advantage in reaching the marketplace on exports. As long as that is there, I don’t see a whole lot of change. If the Canadian dollar were to get remarkably stronger than could you see any impact? may be. But I just don’t see that as a possibility or probability in the immediate future.

Operator

And your next question comes from Ravi Shanker of Morgan Stanley.

Ravi Shanker

I am a lot of focus on crude-by-rail in the near term if I ask a longer-term question terms of the conversation you have with your customers and the constant delays you’re seeing in new pipeline projects. Is this still viewed as a, like, a 3-year opportunity or are you having constructive conversations for longer-term contracts and seen those volumes extend beyond that initial window?

Keith Creel

Well, I’ll let John add color if he’ll like to, Ravi. But discussions when this all started would have been 2 to 3 years is based on pipelines that those expectations have been far missed. There’s so much uncertainty with the pipelines 3 to 4 to 5-year discussion is possible. So I think it extends the tail a bit. I still believe the pipelines will be built. There’s too much of a critical need. There’s just a lot of noise and a lot of hoops and hops to build but they will come. So there’s a bit of a tail to our 2 to 3 when we started this thing, but it’s not going to be for ever tail, which I continue to remind John and the commercial team, we’re making 30, 40-year asset decisions at this company. Certainly not that kind of tail. And we’re not going to overextend our capital — overextend our company based on 4 or 5-year opportunity on a 30 year to 40 year decision.

John Brooks

Ravi. Keith, bang on. Our discussion is just frankly with the producers. These contract lengths are lining up in a 3 to 5 year range.

Ravi Shanker

Got it. Kind of — when you kind of imagine that long-term outlook, I think your peer maybe looking at some growth opportunities beyond just the coal railroad business for acquisitions and such. Can you give us an update on what your M&A pipeline or non-real growth pipeline looks like and if there’s any additional activity there?

Keith Creel

The shortest update is, given our opportunities, our own unique story that CP we’re not interested in pursuing a strategy to buy trucking companies or railroaders. We’re going to continue to play to our core strength. Does that mean we want to get partnerships? Does that mean we won’t take strategic steps to make sure that our customers have a level playing field that can do to win market share based on the strength of our service? We’ll do that but as far as mine trucking companies. We’re not the market.

Operator

And we have no further questions at this time. So I will turn the call back over to Mr. Keith Creel for closing remarks.

Keith Creel

Okay. Want to wrap this up. I will thank everyone for their time this morning, for their interest and shareholders for the quarter trust and your vote of confidence. We had a phenomenal quarter. It’s behind us now it’s in the past. We’re looking forward. We are focused on our convictions to make sure that we continue to meet or exceed our customers’ expectations in the second half of this year as well as our shareholders. So with that being said, we look forward to sharing our third quarter results later in the year. Thank you.

Operator

And this does conclude today’s conference call. You may now disconnect.

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2019-07-16