Canadian Pacific Railway Ltd

TSX:CP

Earnings Call Transcript 2017-Q4

[Operator]

Good afternoon. My name is Mike, and I will be your conference operator today. At this time, I would like to welcome everyone to Canadian Pacific's Fourth Quarter 2017 Conference Call. The slides accompanying today's call are available at investor.cpr.ca. [Operator Instructions] I would now like to introduce Maeghan Albiston, AVP, Investor Relations, to begin the conference.

[Maeghan Albiston]

Thank you, Mike. Good afternoon, everyone, and thank you for joining us today. Before we begin, I want to remind you 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 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, our Executive Vice President and Chief Financial Officer; and John Brooks, our Senior 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 Keith Creel.

[Keith E. Creel, President, CEO & Director]

Okay, thanks, Maeghan. I think it's only appropriate I start by congratulating and thanking the 12,200-plus CP family, which harbored dedication and commitment has enabled these results we're going to review today, both for our shareholders as well as for our customers. I'm extremely proud of what this team has produced, all-time record low, 56.1% operating ratio for the Canadian Pacific; 5% revenue growth; 5% operating income growth; 6% adjusted earnings per share growth, in fact, by nearly every measure we talked about these record results. But with that said, this is an outdoor sport. This quarter was not without challenges. Our team responded to 2 notable [ dramas ] in our Western Corridor in November and battled severe winter weather across our network as we closed up the quarter as well. But in spite of these challenges, the operating results were solid. They enabled us to produce record revenue in Canadian grain and Domestic Intermodal. In fact, in '17, we achieved record or near-record levels for a number of our key commodities. Potash at near record levels, record levels for Canadian coal, Domestic Intermodal, metals and minerals. And an equally encouraging strong performance on the safety front as well, with personal injuries down 16%, train accidents down 21% for the quarter. On a 4-year basis, our train accident frequency finished in all-time low, marking the 12th consecutive year CP has led the industry in this key safety metric. So looking back, after the first year as the CEO of the company, when I think about 2017, I note some excellent progress. I started the year with great optimism for the year ahead and certainly was not disappointed. We finished the year with an operating ratio of 58.2%, the best in our company's history. And we achieved our guidance of double-digit earnings growth. We solidified the team, most recently adding 2 very seasoned and extremely talented sales and marketing executives, leaders to our team in Coby Bullard and Eileen Stone, which John will elaborate a bit about in a moment. We look forward to the investment community being exposed at both Eileen and Coby as we step into our Investor Day in May of this year. We've enhanced our service offering. We've entered new markets. We've repatriated market share. Emphasis added in a key disciplined way. We've had a productive year on the labor front as well, negotiating a number of long-term agreements ahead of expiration, which is a great thing, providing labor stability for our customers and for our shareholders. But it's a wonderful thing when these deals represent what I consider progressive deals, with the thinking, when we partner with our labor organization that we signed these agreements with, with a share in our growth, as we grow forward, tying our success, growing to their individual financial success. On the guidance front, we've built our momentum through 2017. So looking forward, we're carrying that momentum into 2018, and this company, again, is poised for another record-setting year. 2018, we're targeting mid-single-digit revenue growth and EPS growth in the low double digits. I can tell you this, in 25 years of railroading, I've never been more confident in a team's ability to deliver for our shareholders, for our customers and our fellow employees as we write the next chapters of the remarkable CP story. So with that said, I'm going to turn it over to John to provide some color in the markets before we hand it over to Nadeem to elaborate more on the numbers.

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

All right. Thank you, Keith, and good afternoon, everyone. Total revenues were up 5% this quarter, $1.7 billion. RTMs were up 4% year-over-year. Foreign exchange was a 2% headwind, offset by the 2% benefit on fuel surcharge. As expected, on the pricing front, it was offset by negative mix as a result of strong crude, potash, coal shipments, combined with weaker volumes of our automotive and fertilizer volume. Overall, contract renewals continue to move in the right direction, landing in the 2.5% to 3% range. As Keith spoke about, we gained a lot of momentum in 2017 and are executing our strategies in a disciplined manner. We focused intensely developing our marketing team and our strategic playbook for all our commodity areas, giving our sales team specific priorities on how we want to sell, where we want to sell and who we want to sell to. We worked closely with our customers, our core transloads and short line partners to better understand their needs and how we can work together on growth objective. This effort led to the implementation of new products and service enhancements, including our Detroit business and also our Ohio Value Lane, new and expanded transload facilities and increased menu of equipment options and information systems that will provide efficiency and ease of doing business for our customers. Just this week, I'm super excited to host a cross-section of our customers here in Calgary as an advisory council to discuss in detail what they are looking for from CP and how we've enhanced our customer experience. I'm excited about the opportunities that came out of this event. And in 2018, we're going to continue to expand our reach, including a short line conference with our short line partners and work hard to strengthen those relationships and expand our reach into new regions. I recently appointed, as Keith mentioned, 2 new leaders to my sales and marketing team. With this, the leadership team is complete, creating more focus and quicker execution of our strategy. Eileen Stone joined CP from UPS Freight. Eileen brings 26 years of sales and marketing experience to CP. And Coby Bullard joined us from C.R. England and, previously, BNSF, bringing strong trucking and railroad background to CP team. So together with Jonathan Wahba, who joined earlier in the year, this high-performance team is focused on converting opportunities in the marketplace and, as Keith said, driving sustainable profitable growth. Now let's take a closer look at our -- specifically our fourth quarter revenue performance. I'll speak to the results on a currency-adjusted basis and also provide a few comments on our outlook. The bulk commodities were flat this quarter. Potash revenues grew 9%, ramped up with K+S and strong demand from our domestic side. This was partially offset year-over-year with slightly down Canpotex volumes. Heading into 2018, we expect strength in potash, both domestically and export as well as ongoing growth with K+S. On the grain front, we have 2 different stories. U.S. grain revenues were down 14% against tough comps and actually tougher market conditions. Meanwhile, Canadian grain revenues grew 6%. Despite derailments in November and tough weather conditions in December, as Keith mentioned, in our Canadian grain franchise, we delivered record revenue. From an outlook perspective, the Canadian grain crop came in slightly better-than-expected, now near 71 million metric tons. This should provide more opportunity for grain movements as we move midyear into 2018. The U.S. grain market, however, continues to prospect a headwind as we move through 2018. The merchandise and energy chemical portfolio performed exceptionally well this quarter, growing 16%. We continue to see strong growth against many areas of this portfolio. This includes our refined products, our chemicals, our aggregates and our seal business, all these areas exceeding GDP. Frac sand demand continues at a similar run rate as last quarter when we delivered approximately 21,000 carloads. And crude demand accelerated this quarter to approximately 18,000 carloads. So as the outlook for 2018, the merchandise and the energy, chemicals segment overall looks very strong, with support from infrastructure spending, new construction, growing energy-related demand and continued market share gains. And finally, the Intermodal portfolio. We continue to stack quarter-over-quarter improvements. We brought momentum into this quarter, and revenue finished 8% higher. If you exclude [ gain in ] May, we were up at 11%. We saw another outstanding quarter in domestic, with revenues up 15%, hitting record levels on both revenue and RTMs. On the international side, the team continues to build momentum. We now are fully lapped with the Yang Ming contract, and we start 2018 with fresh momentum. At our Vancouver Port terminal, I'll mention CP's on-dock dwell is near all-time record lows, demonstrating our total network capacity and our commitment to operation's excellence with our port partners. With the improving economy, tighter truck capacity and a sales force focused on selling our service in the marketplace, we expect continued momentum in our Intermodal franchise. So let me finish up here. We ended the year strong. I'm very pleased. We see solid momentum growth heading into 2018. And as noted in our press release, we're expecting single -- mid-single-digit revenue growth. I'm pleased with quick progression of my team. I'm excited about the opportunities ahead of us and believe we are well positioned in the marketplace. With that, over to Nadeem.

[Nadeem Velani, Executive VP & CFO]

Thanks, John, and good afternoon. As Keith mentioned, this was another record quarter by almost every measure. Despite some difficult operating conditions and outages in the quarter, we achieved revenue growth of 7% on an exchange adjusted basis, supported by 4% RTM growth. Incremental margins remain around 75%, thanks to disciplined resource management and a well-executed operating plan. Our fourth quarter operating ratio was 56.1%, an improvement of 10 basis points and a new quarterly record. This is an exceptional result, considering we faced costs and operating ratio headwinds, some higher fuel prices, higher incentive and stock-based comp and several network disruptions. During our last earnings call, when I guided to a mid-50s operating ratio for Q4, I certainly didn't expect all of these headwinds, so I'm quite proud of the CP team's ability to deliver. The combination of strong revenues performance and continued cost control translated into record bottom line results. Adjusted diluted EPS was 6% higher this quarter. This is further proof that this operating model is adaptable, resilient and consistently delivers results in any environment. A few specifics on expenses in the quarter. Comp and benefits expense was down 3% on an exchange adjusted basis, largely as a result of higher pension income and operating efficiency. This was partially offset by higher stock-based comp, which I mentioned, incentive comp accruals, labor inflation and increased volumes. Our year-end workforce was 12,200, 5% higher than the previous year but flat since Q2. Fuel expense was up 19%, primarily as a result of higher fuel prices. Fuel prices [ grew ] sharply in the quarter, which created a 100 basis point headwind in the OR. Purchase services increased by $34 million or 16%. In Q4 2016, we completed the sale of our Obico rail yard and recognized a gain on sale of $37 million, which created a difficult comp in 2017. Moving on to full year results on the next slide. This record fourth quarter performance rounds out a record year for CP. For the year, revenues grew 5% and adjusted operating income grew 6%. Our full year adjusted operating ratio was 58.2%, which is 40 basis points better than the record set in 2016. Similar to the quarter, the OR improvement is even more impressive considering headwinds from fuel price, incentive comp and a few favorable onetime items in 2016. Yes, we had help from higher pension income this year, but this was mostly offset by lower land sales. When you remove all the noise, we delivered a full 2 points [ in ] improvement on the operating ratio this year, in cost control and operating leverage. This led to adjusted income growth of 8%, and the benefits of a lower share count from our share repurchase program [ also ] achieved double-digit EPS growth of 11%. We also strengthened our balance sheet this year, ending 2017 with an adjusted net debt to adjusted EBITDA of 2.6x and approaching our targeted range of 2 to 2.5x. Let me take a moment to speak to our 2018 capital allocation. As noted in our guidance, we plan to spend between $1.35 billion and $1.5 billion in capital. The primary reason for the wide range on CapEx is due to the possibility of investing in upgrading our grain hopper fleet, which we've mentioned in the past. We are awaiting the final outcome of Bill C49 before making a decision. That being said, the proposed changes are positive, and investing in a modernized grain hopper fleet would have substantial benefit to both CP and our customers. If all goes as planned, we might begin investing in hoppers later this year, but the timing and full amount is yet to be determined. In terms of share repurchase, you should expect us to complete our NCIB, which we announced last May. So far, we've purchased about half the program at an average cost of $202 per share. One thing to keep in mind as far as future program, in the first half of 2018, we have a total of about USD 575 million high coupon debt maturing, which we refinanced at lower rates. We may also take advantage of the opportunity to actively delever and retire some of these debts, so you should expect lower interest expense in 2018. But at the same time, this would likely push decisions on future share repurchases beyond our current program to Q4. This would allow us to align free cash generation with our shareholder cash return. Also as a reminder, starting in Q1, we will be reporting under our new accounting standard for pension. We will have the details broken down in our 10-K we file next month, but to put the impact in perspective, we applied this new standard to our 2017 results. $274 million pension income would have been reclassified from comp and benefits to other income below the line. $103 million of current service cost expenses would have remained in comp and benefits. This would have had the impact of increasing our 2017 adjusted operating ratio by 420 basis points from 58.2% to 62.4%. A reminder, the impact to net earnings and cash is 0. It is simply a geographic change on the income statement. For 2018, pensions will be at $94 million net tailwind as a result of continued strong returns on plan opposites [indiscernible]. On an apples-to-apples basis, under the new GAAP standards, the breakdown of this is made up of an increase of $112 million in other income, above the $274 million in 2017 I just referenced, offset by an $18 million increase in current service costs from the $103 million we had in 2017. With respect to U.S. tax reform and the impact on CP, our recorded results include a onetime noncash gain on CP's deferred tax liability of $597 million. This has been excluded from adjusted earnings. Our current expectations and guidance for 2018 include a tax rate between 24.5% and 25%, which is 150 to 200 basis points better than our 2017 annualized effective rate of 26.4%. We also expect the cash tax benefit of approximately $45 million to $55 million. I am extremely excited about 2018 and the opportunities we have in front of us. We expect revenue growth in the mid-single digits as our disciplined growth strategy continues to gain momentum. We will continue to drive productivity improvement. And we'll continue to benefit from operating leverage, thanks to high incremental margins. So despite a number of ongoing risk factors, such as currency, rising interest rates and the potential impact that, that may have on the economy, not to mention geopolitical risks, we expect another year of diluted EPS growth in the low double digits and delivering another year of record results. And with that, I'll hand it over to you, Keith.

[Keith E. Creel, President, CEO & Director]

Thank you. With that said, thank you, John. Thank you, Nadeem, for your comments. We'll open it up for the Q&A.

[Operator]

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

[Kenneth Scott Hoexter, Managing Director and Co]

Keith, if you look at your CapEx, I guess, maybe not down as much as could have been. And given your low-double-digit outlook, are you at the point where you need the revenue growth, really, to get the upside to that low-double-digit earnings? Just trying to get where the leverage is. Or is it the lack of buyback? I'm just trying to get where do you see the leverage coming into the business given the growth in volumes you anticipate getting back on board.

[Keith E. Creel, President, CEO & Director]

Relative to CapEx?

[Kenneth Scott Hoexter, Managing Director and Co]

Yes. I guess it looks like your CapEx is kind of starting to inch up a bit or, I guess, it's not coming down as much as would have expected. I mean, it's ramping up to -- in that $1.3 billion down from the -- up from the $1.1 billion back in '16. So it's starting to creep up again.

[Keith E. Creel, President, CEO & Director]

Yes, yes, okay. Well, let me -- number one, we pulled back [ heavy ] and we pulled back early on CapEx, back to the $1.1 billion, because we created tremendous amount of surplus capacity, and obviously, we had to adjust to the marketplace. So we're very strict stewards of our shareholders' capital. So we pulled back. But as we grow forward, the difference of the delta, essentially, for the hopper cars. It's the main primary piece and/or with the projects as we look to grow our revenue streams that would match up with a strong return relative to John's ability to bring on new customers. So it's driven -- I'd say the launch here of it is those hoppers. That's a revenue play and a productivity play, with some incremental revenue tied to John and in project development for us, so it’s stemming [indiscernible] the reach of our network, transload, strategy, those type of things, but none of those are big bucket items. It's just there's some singles and doubles that are out there.

[Nadeem Velani, Executive VP & CFO]

Yes. Ken, just recall, I mean, it wasn't too long ago where we're -- when we bumped it up to a little over $1.5 billion. So as Keith mentioned, yes, we were -- we proactively pulled back early for the freight recession hit. And we're in a strong position of having a lot of very good return projects available to us, and it's a matter of taking advantage of those opportunities as well.

[Keith E. Creel, President, CEO & Director]

Yes. I just think this is symbolic of what we've always said. The first call on cash is internal. If you've got an opportunity to invest money on a greater return, other than returning to a share buyback, that's exactly what we're going to do to grow the company long term.

[Kenneth Scott Hoexter, Managing Director and Co]

I appreciate that. I guess if I can get my follow-up on the workforce. I mean, phenomenal job on the operating ratio, especially as Nadeem mentioned, given the weather and what you've fought against. But workforce up 5% year-over-year, I guess, but more importantly, it's starting to creep up sequentially. Can you maybe provide, or Nadeem, your thoughts on the workforce into 2018? Should we expect to see that ramp up given the volumes coming back on, maybe a relative ratio one versus the other?

[Keith E. Creel, President, CEO & Director]

No. I think you should expect flattish overall headcount. We'll continue to get more productive. That's not going to change in the story. We'll do a little bit more with the last -- we've got to convert our investments as we continue to strategically and surgically extend sightings, to work in yards, to work with debt [indiscernible] in Vancouver. Just our overall mix of productivity initiatives helps us offset those additions. I've got one case in point I'll share with you I'm pretty excited about. We've talked about signing an hourly collective deal in the U.S., being a progressive deal. We had the engineers now, I guess, for 1 year, 1.5 years. Last year, we were able to convert the conductors as well. So our Running Trades employees, south of the border, were on an hourly deal, which means we can get more utility, more productivity out of the employees. So essentially, what we're doing as we grow forward, we're shifting our operation around these. We're shutting down Harvey, which used to be a crew change point for us there. Then we're going down to St. Paul. And essentially, we have been doing this now for about probably 2 months running trains with 2 crews. We leave St. Paul, we'll go to Enderlin, we'll change crews, we go to the border. And actually, vice versa, we come to the border. We'll go to Enderlin, we'll recrew it, we'll put another crew and go down to St. Paul. Then we could go from St. Paul down to the portage, Wisconsin and there into [indiscernible] Chicago. So we're essentially -- from a crew start basis, it's not quite half as much in that [ key corridor ] for us. It's very near it. So it's much lower cost operation, the services improved, the velocities improved and our costs have been dramatically reduced. So it's those kind of things that allow us to continue to stay flattish on the headcount, Ken.

[Operator]

Your next question comes from Fadi Chamoun with BMO Capital Markets.

[Fadi Chamoun, Managing Director and Analyst]

So I want to circle back on the guidance a little bit. You mentioned headcount, kind of flattish. Can you improve OR in 2018? Or are there, I guess, some things working against you compared to last year?

[Keith E. Creel, President, CEO & Director]

We're definitely -- we definitely see line of sight to improvement in the operating ratio, Fadi.

[Fadi Chamoun, Managing Director and Analyst]

Okay. Can you talk about the potential magnitude given the top line growth that you're going to see this year [indiscernible]?

[Keith E. Creel, President, CEO & Director]

Looking at it right now, I would say, based on -- there are some uncertainty in the marketplace as far as demand, but our best guess, it's going to be somewhere between 100 and 200 basis points.

[Fadi Chamoun, Managing Director and Analyst]

Okay. And when you look at their top line kind of outlook going into 2018, like what do you think could provide potential surprises to the upside? And maybe, specifically, are you assuming the crude business continue to build into 2018 or you're not assuming that?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Fadi, it's John Brooks. I think we expect sort of the Q4 run rate on crude to continue. I could tell you, certainly, the demand has come on strong in that area, but we're being really strategic on how we're bringing it on. So I think there's going to be opportunities as the year progresses. And -- but we're going to pick our partners [ lively ], and we'll see what -- how that crude materializes. But frankly, I look across all the other commodities, with maybe the exception of U.S. grain and a few other bits and pieces there, things look generally positive. I think we got a heck of an upside in the potash market. And we'll see what Teck guys do, but I think there's opportunity on the coal front and then our chemicals and sort of non-crude energy business. Refined products has been pretty solid also.

[Keith E. Creel, President, CEO & Director]

And I think a key point to keep in mind, Fadi, we -- number one, we've got capacity on this railway, but this operating model and the progress we've made over the past several years, we've created capacity. And in this environment we're faced with today, by and large, day in, day out, those customers are recognizing, number one, the need for reliable service and the value in that capacity. So we're going to make sure that we, to John's point, partner strategically with those that appreciate that capacity. We're not going to allow ourselves to be commoditized. And we're going to bring value to the bottom line, both to the customers as well as our shareholder, on the basis of the strength of this franchise, the capacity we have, that we can get to in very short order, at very minimal capital expense, if any, with a very engaged workforce.

[Operator]

Your next question comes from Walter Spracklin from RBC.

[Walter Noel Spracklin, Analyst]

Looking at revenue guidance, is it possible that you could give us a little bit more color on how much mix is going to impact your revenue guidance and whether -- are you going to hold the line on price, and therefore, how that mix affects your volume outlook for 2018?

[Keith E. Creel, President, CEO & Director]

Well, [ I'll leave ] the price question for John and for you. We're definitely holding the line. As I've said, we've got a valuable commodity here and capacity in service, and we're going to make sure we extract a fair price for that. Now I'll let John speak to the mix point, Walter.

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. Walter, I think we're going to have a mix headwind that's sort of ongoing into 2018. We've got -- there's no doubt, I think if crude continues to grow at some point during the year, I expect fully strong potash year, as I mentioned, and also the coal front. On the Automotive front, which is typically a highly sense [indiscernible] RTM, there's not a lot of huge opportunities as we move through 2018 in the automotive front. So I expect weaker volumes on that and also fertilizer. So I expect mix to continue to be a headwind. We'll kind of have to see how it plays out in terms of how far it balances out the price that Keith spoke about.

[Walter Noel Spracklin, Analyst]

Okay. And in term -- and both of you have mentioned there are some opportunities for some share gain with contract renewals coming up in 2018. Is it safe to assume that you're not including those in your guidance for next year and that would be upside? And if so, Keith, you mentioned capacity, how much more revenue growth could you take on or volume growth could you take on before you think capacity might become a little bit constrained?

[Keith E. Creel, President, CEO & Director]

The best answer, relative to the capacity, it depends on the lane and it depends on where it is. Obviously, if we're talking about additional train starts with additional bolt trains, you get to a point where you look at locomotives, potentially, although we have locomotives in the storage, so that's not a huge concern. But by and large, capacity, unless it's a [ stepped ] increase in business, I'm not concerned. It's a matter of hiring employees, training employees. There's about a 6-month window. From the time we pull the trigger, we try to keep the headcount tight, obviously. We try to control that and match that time frame against business. So with that said, that's really the only lever I'd pay the most attention to. So I don't think we have any issue in that. And you're right with the assumption on the guidance. We're not baking in, and there would be some upside if we had a significant contract win there, to your first question, Walter.

[Operator]

Your next question comes from Chris Wetherbee from Citigroup.

[Christian F. Wetherbee, Vice President]

I wanted to touch a little bit on, when you think about the guidance for next year, how should we think about land sale opportunities, both from an OR perspective, I guess, maybe an EPS perspective, if they run through the operating results as well as maybe from a free cash perspective? Should we start seeing some acceleration in those numbers? I just want to get a sense on how you guys are thinking about it and whether it's included in your guidance.

[Nadeem Velani, Executive VP & CFO]

Sure, Chris. As we mentioned last quarter, we had one deal we expected to close in 2017 that's being pushed into 2018. You should assume a magnitude of about $50 million to $60 million of land sales, lumpy. But I'd say, Q2 and beyond, I would assume in terms of free cash that, yes, we're going to see a good ramp-up in free cash. You should expect $1 billion plus, $1.1 billion probably as a fair number, that type of magnitude.

[Christian F. Wetherbee, Vice President]

Okay. And the $50 million to $60 million is also in the EPS guidance?

[Nadeem Velani, Executive VP & CFO]

Yes.

[Christian F. Wetherbee, Vice President]

Okay. And then you mentioned in the prepared remarks about some deleveraging opportunities, and obviously, you're moving towards your leverage target, following some of the tax law changes. Are there opportunities for you from -- to move some of the debt from the U.S. to Canada? I don't know what sort of the opportunities are in that respect, but the tax law changes sort of present some incremental opportunities, which could maybe drive that tax rate sort of maybe lower than the range you're giving us for 2018 when you look out to 2019 or beyond.

[Nadeem Velani, Executive VP & CFO]

Yes. It's certainly something that we're looking at. I don't have an answer for you now in the sense that some of the recent changes with the tax reform. We're working through the various opportunities. We're going to do what's right and what's best for the business at the bottom line. Certainly, when we look at debt and some of the -- your capital allocation as well, it's all tied in. And we will continue to look at where we can best use our cash and where we can best take advantage of opportunities from a leverage point of view as well. So I don't have a firm answer for you right now, Chris.

[Operator]

Your next question comes from Turan Quettawala with Scotiabank.

[Turan Quettawala]

I guess I want to just talk a little bit, if you could, on the potential -- or the trajectory of growth for 2018. Is it fair to assume just looking at the volume numbers and the lap periods from last year? Or is it something else specific that might change that trajectory a little bit?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

No. I mean, again, as I said, I think most of the commodities look green in my eyes. We've got a good opportunity in terms of continued, I think natural share rebalance out there in the marketplace, other than U.S. grain, which I certainly see a headwind. And certainly, I guess, there's uncertainty as we get into new crops for Canadian grain and some of those pieces, that the rest of the area presents a good upside.

[Turan Quettawala]

I guess, I'm sorry, go ahead John. Maybe I didn't ask that properly, but I was talking more about sort of the quarterly breakdown. Is it more like this Q1's a bit of an easier lap and then Q2 is a bit of a really harder lap, I guess? How do I think about that from a volume growth perspective on a quarterly basis?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. I've got you. Okay. Sorry about that. Yes, definitely. We -- that will progressively, quarter-over-quarter, get tougher as we move through the year.

[Turan Quettawala]

That's helpful. And I guess if I could ask just one more on the crude by rail. You've talked a little about sort of getting strategic partnership with some these players. I guess I was wondering, to the extent that you can help us here, are the oil companies at all interested in getting some type of longer-term commitments? Or is that what you're trying to get? Or, like, if you could give us some color there, that would be helpful.

[Keith E. Creel, President, CEO & Director]

Yes. We're not talking about longer-term commitments. We're talking about strategically aligning with customers that do other than ship crude. So we understand crude is only going to be here for a certain period of time. We're looking for strategic partners with long-term objectives that align with ours that allow us to have a more stable book of business, and that sort of falls in line with rebalance in business and -- which serves our franchise well, how we can bring value to the bottom line, to help them move their assets, to lower their transportation costs while we bring value to our shareholders. So those are the type of customers that we're talking about, customers that do business not only in crude but also other lines.

[Turan Quettawala]

So I guess, Keith, does that sort of mean just getting a bigger share of the wallet for the customer overall? Is that kind of what we're talking about?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

That's correct of the overall book. That's exactly what we're talking about.

[Operator]

Your next question comes from Brandon Oglenski from Barclays.

[Brandon Robert Oglenski, Vice President and Senior Equity Analyst]

I apologize in advance. It's going to be a nerdy analyst question for you and Nadeem. But can you go back to the...

[Nadeem Velani, Executive VP & CFO]

We're used to it, Brandon. Thanks.

[Brandon Robert Oglenski, Vice President and Senior Equity Analyst]

Well, I think you called out pension income moving up about $100 million this year. Is that right?

[Nadeem Velani, Executive VP & CFO]

Yes.

[Brandon Robert Oglenski, Vice President and Senior Equity Analyst]

Okay. And then if I heard Keith right, I think you guys are looking for about 100 to 200 basis points of core margin improvement, so thinking about 2017 and moving the pension income out. But nonetheless, I think when I do that math, plus mid-single-digit revenue growth, we're getting to earnings growth that would be probably north of mid-double digits. So I guess how do you reconcile that to your full year earnings forecast?

[Nadeem Velani, Executive VP & CFO]

I'm not sure I answer nerdy analyst questions, Brandon. No, I think there's a couple of things. Certainly, if you want call the conservative a little -- the guidance a little conservative, you can call it conservative. There are some headwinds that currency, you can say, were in the range -- the currency fall right now is below our guidance. It's [ $1.24 ] and seems to be strengthening more than -- the Canadian dollar seems to be strengthening, which is -- which could be a headwind for us as well. Same thing you're going to ask for fuel prices, right? That does hurt the OR and could challenge the 100 to 200 basis point improvement. So it's just -- it's so early in the year. Would we like to do better than the low-double-digit guidance? Absolutely. I just think it's -- we think it's the prudent thing right now, in early January of the year, to have guidance that we think is very achievable. So...

[Brandon Robert Oglenski, Vice President and Senior Equity Analyst]

I appreciate the response. And I guess, Keith or Nadeem, the markets can get really fixated on OR. So just given this real estate change with pension accounting, do we still think a low-60s or maybe even a high-50s OR is the right place to run this business? Or do we look at top line opportunities and say a slightly higher OR is okay?

[Nadeem Velani, Executive VP & CFO]

I mean, Brandon, we've always talked about in the -- before this pension change, that we're capable of getting to a mid-50s operating ratio. It's going to -- like I said, it would be about a 400 basis point change with the accounting standards. So mid-50s [ would ] get a high-50s. So we do think we can still improve the OR from low-60s to -- back to something with a 5, may not be this year, may not be -- might take a couple of years to get back to that level. We're not fixated on the OR. It's kind of a product of what we do to reinvest in the business. I mean, we're focused on return on invested capital. We're focused on the earnings growth as a whole. So I think if you do all the right things in those areas, typically, you also get a very good OR. So...

[Keith E. Creel, President, CEO & Director]

Yes. The magic recipe here is not so magic. We've been doing it for a while. I've been doing it for a couple of decades now. You control your costs. You deliver great service. Operating ratio is a natural positive outcome of that but, most importantly, drive earnings growth. That's what our shareholders want. I think that's what they appreciate, certainly, I appreciate as a shareholder. And that's what's ultimately going to be what leads us to the right decisions.

[Nadeem Velani, Executive VP & CFO]

But you shouldn't take this release and our comments in any way to think that. So we don't think that we could have the strongest OR or the best OR in the industry, which I'm predicting we probably will have this quarter.

[Operator]

Your next question comes from Tom Wadewitz with UBS.

[Thomas Richard Wadewitz, Managing Director and Senior Analyst]

So Keith or John, I just wanted to get some thoughts in terms of how you're -- your broader look on volume versus price seems that, I guess, maybe it's more true for the North American Surface Transportation capacity situation, but things seem really tight in truck, pretty good outlook for volume on rail. And there's an effect from what your competitor does. But how do you think about kind of volume versus price and whether you would expect a little bit of acceleration in price as a function of some tightness, which seems to be the case in the market?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. Tom, I guess just a couple of comments. I think, certainly, we have seen, through 2017, an uptick just about every quarter. So I don't think anything has changed. If anything, that capacity that you spoke about probably continues to get a little tighter as we move into 2018, and I think that does present an opportunity. I mean, certainly, our position, and Keith has been loud and clear on it, I've been loud and clear with my marketing and sales team, that we want to try to capitalize on some of that opportunity. We've maybe seen a little more action on some of our cross-border and stuff in the U.S. in terms of direct tightening of truck capacity, but again, I expect that to sort of spread north through our Canadian market as we move into 2018 and present a fair amount of opportunity in our Domestic Intermodal space.

[Thomas Richard Wadewitz, Managing Director and Senior Analyst]

So would you say that -- how should we think about the price that's embedded in your guidance? Is it kind of a 2.5% to 3% type of price. And also the potential for that to be above that level and maybe drive upside to the guidance.

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. So you're right. I think we are in that 2.5% to 3%. And Keith was shaking his head. Yes, I think we do believe there's some upside to that as we look into 2018. Look, I don't know if that -- those, the 3.5% or 4%, or that -- we'll just have to see how that plays out.

[Thomas Richard Wadewitz, Managing Director and Senior Analyst]

Okay. But that would be upside versus what you've got in the kind of earnings and revenue guidance?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes, for [ IPS ] comp.

[Operator]

Your next question comes from Benoit Poirier from Desjardins.

[Benoit Poirier]

Could you maybe talk a little bit about the assumption for FX and fuel in 2018, Nadeem, what you're assuming?

[Nadeem Velani, Executive VP & CFO]

Yes. We've assumed $3 for OHD, and currency of -- in the range of $1.25 to $1.30.

[Benoit Poirier]

Okay. Okay, perfect. And could you talk a little bit about the ramp-up at K+S, I mean, whether there is further growth opportunities or whether you're at full capacity or -- an update on K+S mine, please?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. So Benoit, they actually ramped up pretty good the back half of the fourth quarter. I think their objective is ultimately to get to that 2 million tons. I think -- I'm not sure that's going to be a 2018 number at all, but certainly, we expect them to get in that 1 million, 1.5 million range.

[Operator]

Your next question comes from Ravi Shanker from Morgan Stanley.

[Ravi Shanker, Executive Director]

So this may sound like a 2018 question, but I promise, it's actually a bigger picture question. Keith, both you and Nadeem said that you're really excited about 2018, and certainly, in our most recent shippers survey, some of the numbers that came back were kind of eye-popping in terms of how bullish people are. Yet, your guidance on the volume side points to pretty much low single-digit growth, if you're going to back into that. Is this kind of the range we think of for the rails going forward, where kind of maybe close to peak of cycle and if things are going really well, you're growing volumes like low single digits? And then what's the downside when things are worse? I'm just trying to figure out what that range of volume growth looks like at various points in the cycle.

[Keith E. Creel, President, CEO & Director]

Well, our guidance is actually mid-single digit, which exceeds what GDP would give you naturally. This company is still in -- still writing chapters about repatriating business, about winning business based on our service offering. So again, there are puts and takes in that. But by and large, to John's point, there's -- the macroeconomic as well as the micro specific to CP environment is favorable. So I expect this company over the next year to 2, to 3 years, [ that guess I can make ], based on the information I've got in front of me, to exceed what normal GDP growth is. I've got a couple of points. There's opportunity out there to convert them. We're a bit conservative in our guidance. We've got to work hard to achieve it. We're not going to get arrogant. We've got to be humble and [indiscernible] customers' business every day. But this operating model and this franchise, there's a lot of opportunity to create value for our customers. And we're knee-deep in the middle trying to create that.

[Ravi Shanker, Executive Director]

Got it. And just a follow-up to that. There's been some talk recently about NAFTA and then some concerns for coming out of Canada that NAFTA may be changed and it's [ got informed ]. I'm just wondering kind of what your current view is on that and what CP's exposure. Or kind of what are you thinking of in terms of bull, bear-based scenarios, if there were to be a change with NAFTA?

[Keith E. Creel, President, CEO & Director]

Okay. My concerns on that is more the macro level. What does it do to the broader North American economy? On a micro level, number one, we're staying very close to this myself, staying close to the Minister of Transportation, the Minister of Foreign Affairs on how this does potentially could affect commerce between the 2 countries as well as the U.S. Ambassador to Canada. So it's something topical for us. We're paying attention to it. But at a micro level, our direct commodity exposure is fairly modest. 30% of our business is cross-border. But this number overstates our true exposure. Our cross-border is primarily agriculture products, stuff like grain, potash, fertilizers, chemicals, some autos. Again, autos is not a huge piece of our business. It's about 3% of the book, so crude and forest products, which is handled outside of NAFTA. And the reality is, the U.S. relies heavily on these raw materials that we're shipping south to support the overall economy. So at the end of the day, macro concerns, not as much micro, certainly, we'll stay close to it. Worst-case, if NAFTA is repealed, we feel that we're going to go -- revert back to what existed before, which is an agreement between Canada and the U.S., some free trade and/or, worst-case, [ WTI ] levels. Commodities, like crude and fertilizers and steel, they wouldn't have any tiers at all. So at the end of the day, we're going to pay attention to it. I still think it's early in the game. I'm starting to see some signs that Mr. Trump is probably seeing the same things we see that makes a whole lot of sense to have healthy commerce and trade between these 2 countries.

[Operator]

Your next question comes from Scott Group from Wolfe Research.

[Scott H. Group, MD & Senior Transportation Analyst]

So I just wanted to follow up on, I guess, Brandon's question earlier about some of the moving pieces in guidance. So if we're doing the math right between pension, interest expense, share -- tax rate and real estate, you get like 11%, 12% earnings growth just from that. And Nadeem, I think you laid out a couple of headwinds. Is there any way just to help quantify what the headwinds are that you see that sort of offset that? I know you've laid out fuel and currency or maybe something else, but can you help quantify what those headwinds are?

[Nadeem Velani, Executive VP & CFO]

Yes. I mean, if you look at currency alone, if you take the spot rate and play that out, I mean, that could be $0.30 or 3% EPS headwind. Fuel is more of a notional headwind on the operating ratio rather than really an earnings headwind, but I'd point out to that. And then I'd just point to what we just -- the previous question from Ravi about NAFTA and uncertainty and what that -- what could change from a demand factor with rising interest rates, what could change from any sort of geopolitical tensions or any sort of pulling out of NAFTA, what that could mean to the overall economic environment. But I think you've captured it well. There are some more tailwinds than there are headwinds. And there's probably more upside than there is downside risk. Again, I'd just say it's early in the year, and you never know what's going to happen with the crop year. You never know what's going to happen with weather. You could have a challenging January, February with weather and so forth. And so I think it's just the prudent thing right now to lay out a low double-digit EPS scenario.

[Scott H. Group, MD & Senior Transportation Analyst]

Okay. Fair enough. That makes sense. And then for John, can you explain why you think the run rate for crude doesn't move further -- doesn't move up more, just given where differentials are and where production is coming? And then just maybe along those topics of crude growth, and you talked about the mix. Relative to that 3% or so pricing that you're expecting this year, order of magnitude, is mix similar sized to that on the headwind or any sort of directional color on size of mix?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. On the mix comment, it could be. It could bring in the price mix close to flat. Again, well, it sort of depends on if -- to your first point, if more crude does come on and we find those partners that Keith spoke about and those opportunities [ weren't ] materialize, that can sort of continue to drive that mix issue. So it could balance that out. Look, the crude demand, no doubt, has accelerated. And I think we are doing what we've said we were going to do from day 1. We're going to be very prudent. We're going to be cautious. We've been burned before in this market. If the mobile resources are available, the opportunities make sense with the right partners, we'll move on it, and we'll move swiftly and we'll capture those opportunities. But we got a volatile weather or winter weather operating right now, we've got a lot of grain to move. We've got operating challenges with other railroads in North America. So balancing all that is the prudent thing to do right now. And look, as we get into the spring and we sort of see what's going on with grain in other areas and if we can pick those right partners, yes, I'd say there is some upside.

[Operator]

Your next question comes from Steve Hansen from Raymond James.

[Steven P. Hansen, Senior Vice President]

Just a quick one for me. As it relates to the new services, John or Keith, can you just explain some -- describe some of the traction you've been seeing with your new service offerings or thoughts on that, that you described and perhaps what you might be planning for 2018 in terms of adding to those?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. So I don't have our latest Detroit volumes in front of me, but I can tell you, we've -- it's been wildly successful. Our partner, Hapag-Lloyd, has been very pleased with our performance in that lane. We're delivering the service and transit that we had expected in that lane. We think it's going to be an attractive service for some of the contracts we're working on. We're working toward the launch of our Ohio Valley service here in, I would say, let's call it, the next 30 days. Again, we're excited about the sort of backhaul reload opportunity that, that's going to present and, again, give us more optionality with some of those intermodal customers. I'm excited about a new ag transload that we're on the cusp of announcing maybe a little deeper here in the -- probably the next month, in the Twins Cities areas, again, to give our intermodal customers sort of a broader opportunity for the RP and export lane back out of Vancouver. I still see a pretty tremendous transload opportunity for us in the Toronto and Hamilton area. We've recently made some investments and some warehousing and liquid hazmat and non-hazmat transload opportunity in Hamilton that I think brings a fair amount of incremental opportunity. And I can tell you, there's -- the list sort of goes on, but I can't tell all my secrets.

[Keith E. Creel, President, CEO & Director]

I think the last material main point, had about [indiscernible], a week from Sunday, I guess, John and I and the team, we're heading over to Asia to open up our Asian office located in Shanghai. So we'll be over there doing the grand opening and connecting with customers and educating them about the service offering and the value that this railroad brings to the table in North America. So that's something else that we're pretty excited about.

[Operator]

Your next question comes from Brian Ossenbeck from JPMorgan.

[Brian Patrick Ossenbeck, Senior Equity Analyst]

So clearly, you've done a very good job staying disciplined pricing for the value of the service and not chasing volume, but now that the market looks more supportive, competitive, dynamic, it's probably gotten a little bit easier in the last couple of quarters. And what sort of controls, incentives are there in place at CP to make sure you follow the quality of revenue and not just the revenue?

[Keith E. Creel, President, CEO & Director]

We measure. And actually, our compensation programs have a measurement in there, where the quality of the revenue is part of the measure. So number one, can be compensated for it to receive the commission, for it to count, versus your objective, it's got to qualify and meet those minimum profitability and margin thresholds before it even counts. So there are definitely some very surgical-focused measures that specifically speak to quality of revenue. We're not going to grow for the sake of growing. We're going to make sure we can bring it to the bottom line that are embedded into our comp or our marketing team.

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. To build on that, Keith is bang-on. We actually, for 2018, significantly increased our -- what we'd call our price component and quality of revenue component for that compensation for our sales team. They're motivated to drive that area, no doubt. And I've got people on my team that are the judge and jury on that, making sure that, that's paid out in the right manner. So yes, we all have to check imbalances and hold each other accountable and the constructive tension that Keith speaks out that allows us to be effective.

[Brian Patrick Ossenbeck, Senior Equity Analyst]

Okay. Good. That's good to hear. We've seen some discipline not quite hold in recent times. So that card does help [indiscernible]. Last quick one was just you talked about taking market share, growing existing customers but, more specifically, converting trucks off the road. John, how much of the book of business would you say is exposed to true truck competition, both in U.S. and Canada, where you can actually get loads onto the rail and off the road?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Well, I don't. It's certainly -- a fair chunk of Domestic Intermodal is all sort of exposed to that area. It probably is a lesser degree as we go down the rest of the commodities. I'd say this, we -- the Domestic Intermodal team at CP has done a heck of the job, frankly, the last 3 years. The growth in that franchise and converting the service has been sort of paramount, has been the focus and it's carried with it disciplined pricing. And as I look into 2018, and actually, I would remiss, we're talking about the commodity areas, where we've got growth opportunities and headwinds, I failed to mention Domestic Intermodal. But there is no reason that we can't stack another year like 2017 onto that. And I do believe, and I don't know if it's 30% or 50% of that growth, but can come off the road. I still believe there is a -- as Keith talked about deepening CP's presence in our customers' total book of business and total wallets, there's a lot of over-the-road conversion out there that still exists, and we're keenly focused on it.

[Operator]

The next question comes from Allison Landry from Crédit Suisse.

[Allison M. Landry, Director]

So you guys talked about the Bluegrass JV starting up, and you've telegraphed in the past looking for more of these deals. So just curious of any additional -- if there have been any additional ones that you've identified that have a reasonably high probability of occurring. And then, longer term, are these types of partnerships the key to GDP plus volume growth or even outsized growth relative to your peers?

[John Kenneth Brooks, Chief Marketing Officer & Senior VP]

Yes. I'd say this, right or wrong, CP in some of those areas, whether it be with short line partners or connecting roads, had lost little focus. And in 2017, I think with the Ohio Valley and some of these opportunities I spoke to, we're bringing that back in, and we're prioritizing that extension of reach in some of those opportunities. I would [ emcee ] and say certainly, I think as I mentioned, we are going to embark as aggressively as we do in terms of sales with our customers. We are going to aggressively sell with our short line partners in 2018. And I think naturally, whether it be for our autos franchise or bolt-on for our intermodal franchise or, frankly, our carload franchise, I think there does present a new opportunity. Are there ones that I'm ready to tee up and talk about today? Not quite yet. But I would say I'm fairly optimistic that the first half of this year, we've got a few more of those pulled out of the playbook.

[Allison M. Landry, Director]

Okay. That's great. And I just -- and my follow-up question relates to the PTC. How should we think about the maintenance expense in 2018? I think you mentioned previously something in the $40 million to $50 million range. So is that still the right way to think about it? And then do you think that the productivity benefit from PTC itself can offset this? Or are those in the flow-through later on as the system is more fully rolled out perhaps in 2019 and 2020?

[Keith E. Creel, President, CEO & Director]

Yes, the -- well, the operating expense, I think we've got a little confusion I'll have to clear up. The operating expense for us is not material. We're going to absorb it. There'll be some levels of productivity. So we're not going to speak to operating expense, meaning material impact to the company. The $45 million to $50 million you're talking about is actually our capital outlay investing in PTC, which, after we get through '18, it's about $45 million, $50 million. We're looking at about the same number for 2019, and then it falls away. And we'll have that space within our existing capital envelope to deploy elsewhere.

[Allison M. Landry, Director]

Okay. Got it. So just to be clear on the sort of net maintenance expense, so you're saying that whatever the maintenance expense is, that will be offset by your PTC productivity benefits?

[Nadeem Velani, Executive VP & CFO]

No. We're absorbing it. Is it in our cost structure today a little bit higher? Absolutely. But it's nothing else in that we can't overcome through other productivity. We're not going to say it's coming directly from PTC savings, but to us, it's a headwind you overcome through other cost initiatives.

[Operator]

Our last question comes from Seldon Clarke from Deutsche Bank.

[Seldon T. Clarke, Associate Analyst]

So you talked a lot about items on both the revenue and cost side, which we don't need to rehash. But if you just do some quick math, you get to an implied incremental margin, like close to 45%, somewhere in the mid-40s. Is this the right way to think about like the business longer term in kind of this like post-precision railroading world? Or are there some more kind of -- or some higher cost inflation in 2018 that like, I guess, won't continue longer term?

[Nadeem Velani, Executive VP & CFO]

Well, I think one thing that you should factor in as well, I mean, we have an assumption on stock-based comp that we're going to perform well, and that's the stock we'll continue to run. And so that's going to be an embedded cost factor, I mean, depending on how you do your incremental margin calc. It's something you might want to [ exclude ]. But -- so I'd just point that out as kind of one item. But no, there's nothing material in terms of increased inflation and so forth. I mean, this is guidance that we're giving you in January on where we see the things in the year unfolding. Certainly, I've talked about our 75% incremental margin that's being something that we feel good about and confident about. So I'd say let's hear [indiscernible] our Q1 results come through and let's talk about the incremental margins on actuals, and then we can have a bit more of a wholesome discussion over actual results. So...

[Seldon T. Clarke, Associate Analyst]

Okay. All right. That's helpful. And then if you look at just CapEx and take out the grain stuff, I think you're implying somewhere close to 20% of sales. Is that a good run rate to think about longer term?

[Nadeem Velani, Executive VP & CFO]

It's -- I find the percent of sales as a difficult ratio and not something that we really even look at. It could be impacted by a number of things, currency, fuel surcharges and so forth. I think a fair number is that range we gave you. We have pretty significant numbers tied to -- potentially to the covered hoppers. So I'd say a range of $1.3 billion to $1.5 billion is a good number to think about and utilize over the next several years.

[Seldon T. Clarke, Associate Analyst]

Okay. And then just quickly -- okay, that makes sense. And then just quickly, was there anything in particular in Q4 -- I think just CapEx came a little bit higher than we're anticipating. Was there anything particular in Q4 that drove that?

[Nadeem Velani, Executive VP & CFO]

We pulled forward some opportunities in Q4. And so we had some opportunities to pull forward on the engineering side that we did, and that was why it got a little lumpy.

[Seldon T. Clarke, Associate Analyst]

All right. So that's why you wouldn't really see much growth, excluding the grain stuff.

[Nadeem Velani, Executive VP & CFO]

Right.

[Operator]

And that was our last question at this time. Please continue.

[Keith E. Creel, President, CEO & Director]

Okay. Well, [ let's get a wrap up ] our comments today. Let me close in saying we had a very solid 2017. We set ourselves up for a very positive 2018. We certainly did not expect to disappoint our shareholders. We've got a best-in-class team. They're energized, that energized workforce. We've got some very viable capacity out there that we're in the marketplace converting. But I caution you and I had emphasis to control sustainable growth. With that said, I'll wrap up the call, and we look forward to sharing our results end of the first quarter. Thank you.

[Operator]

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