Canadian National Railway Co Q2 FY2020 Earnings Call

CN Second Quarter 2020 Financial Results Conference Call will begin momentarily. I would like to remind you that today's remarks contain forward-looking statements within the meaning of applicable securities laws. Such statements are based on assumptions that may not materialize and are subject to risks described in CN's second quarter 2020 financial results press release and analyst presentation documents that can be found on CN's website. As such, actual results could differ materially. Reconciliations for any non-GAAP measures are also posted on CN's website at www.cn.ca. Please stand by. Your call will begin shortly. Welcome to the CN First Quarter 2020 Financial Results Conference Call. I would now like to turn the meeting over to Paul Butcher, Vice President, Investor Relations. Ladies and gentlemen, Mr. Butcher.

Well, thank you, Patrick. Good afternoon, everyone. And thank you for joining us for CN's second quarter 2020 earnings call. I would like to remind you about the comments already made regarding forward-looking statements. With me today is JJ Ruest, our President and Chief Executive Officer; Ghislain Houle, our Executive Vice President and Chief Financial Officer; Rob Reilly, our Executive Vice President and Chief Operating Officer; Keith Reardon, our Senior Vice President, Consumer Product Supply Chain; and James Cairns, our Senior Vice President, Rail Centric Supply Chain. I do want to remind you to please limit yourself to one question so that everyone has the opportunity to participate in the Q&A session. The IR team will be available after the call for any follow-up questions. It is now my pleasure to turn the call over to CN's President and Chief Executive Officer, Mr. JJ Ruest.

Thank you, Paul. And good afternoon, everyone, and welcome to our second quarter earnings call. In keeping with our commitment to safety and essential services, our people have quickly pivoted to working safely under the new normal of COVID-19. In Q1, we told you about our proven ability to be resilient to any challenges. In Q2, we proved it again, and CN’s operation never slowed down for the pandemic. And we will be ready and prepared if there is a second wave. As we look back, this was among the toughest quarters of my career with heightened pandemic concern for our employees and a sharp drop in volume of 18% in revenue ton miles. But thanks to our people and our leaders, we performed very well. We take pride in delivering essential services to our national economies. Our perennial financial strength is serving us very well in these current times. CN generated $1 billion free cash flow during a quarter of severe recession. We delivered an adjusted operating ratio of 60.4% and we caution you to aim for a minimum of $2.5 billion of free cash flow this year. CN is built to last. And even in these challenging times, I'm proud that we continued to demonstrate why ESG is a hallmark of CN. Namely, our carbon footprint continued to decrease having delivered another record of fuel efficiency. Today, we will speak for the short term, our costs and our resiliency to last this pandemic. And today, we will also speak to our investment in the long term and our contribution to the economic recovery. Rob will walk you through the strength of our operation in this new normal. He will highlight progress we are continuing to make and cost takeout and bringing technology to the railroad industry and then the safety culture at CN. He will also highlight his outstanding performance in fuel efficiency. James and Keith will speak to the expected sequential volume trend for the quarters ahead. And we know also by now, our long-term commitment to the grain business and the management investment that we've announced here today. Ghislain will give you color on our solid balance sheet and the special non-cash charge that we are using to PSR further by trimming non-core parts of our network. So in summary, a good quarter in the middle of a recession. We quickly learned how to operate under the new normal of COVID-19 for quarters to come. We proved again our cost resiliency that will help us deliver in the near term. And we reaffirmed our confidence in the future by maintaining our dividend policy, reaffirming our $2.9 billion CapEx in 2020, and announcing a new $150 million investment for 2021, targeting the long-term grain export business. On that note, I will pass it on to Rob.

All right. Thank you, JJ. Our results in the second quarter are showing you the strength of our CN team and our operating model. In these extraordinary times, the team reacted quickly and aggressively. We adjusted resources to declining volumes, increased productivity and efficiency, and served our customers, all of that while improving our overall safety record with fewer injuries and fewer accidents on a year-to-date basis. Finally, we will see some lasting structural changes following COVID-19 and I'll provide you with some examples. I'm very proud of the CN team that proved again our culture of operational resiliency as we are leading the industry on many fronts. Now, let me walk you through some of the details. During the quarter, the team responded accordingly to the significant volume drops in right-sizing our resources, idling four locomotive shops, as well as four additional switching yards. We laid up one out of every three locomotives, over 20,000 railcars were stored while our active online car inventory was down 20%, and approximately 4,000 employees were furloughed this year. From a productivity standpoint for the second quarter, the team set an all-time best ever fuel efficiency record while avoiding an additional 29,000 tons of CO2 emissions and saving an additional $7 million in fuel expense, directly from our fuel efficiency initiatives and execution. Sequentially, fuel efficiency improved 8% from last quarter. That means we moved 8% more tonnage the same distance with the same amount of fuel. We continue to be the North American Class I railroad leader in fuel efficiency using a little more than eight-tenths of a gallon of fuel per 1,000 gross ton miles. Train weight and train lengths reached all-time historic levels as we're able to move more freight on every train start. Crew starts were reduced 21% while RTMs were down 18%. Crew productivity exceeded all-time record levels and train speed was up 5% year-over-year. As I noted last quarter, we also took advantage of the additional time on our tracks with fewer trains operating to strengthen our infrastructure. As a result, we've seen our rail un-tagging productivity improve up to 25% year-over-year. Also, as I've mentioned previously, from a mechanical standpoint, we reacted with a plan and a purpose by laying up our least reliable locomotives first and laying them up in good order status that allows us to get them back into service quicker, when needed. During the quarter, we've seen locomotive reliability and availability percentages improve year-over-year, while locomotive dwell was reduced, fully utilizing our assets while doing it with fewer shops and less headcount. You can see that we once again demonstrated our culture of operational resiliency, even during a tough quarter, and we continue to look ahead to further improve our efficiency through challenging times. Now, let me highlight some initiatives we are building upon that will provide lasting structural changes. The idled locomotive shops and switching yards will remain closed. We will continue to improve train size year-over-year. Fuel efficiency initiatives will continue to produce record outcomes. More of our training will be performed virtually. And we continue to advance the capability of our handheld mobile devices that all train crews have now. Through this digitization process, we have and are eliminating some 30 million printed pages of paper annually at CN, removing hundreds of shared printers and kiosk terminals while reducing the COVID-related exposures associated with them. Further on a technology forefront, our automated track inspection program in automated inspection portals continue to provide benefits with our train accident ratio reduced 22% year-over-year. Finally, our operations team is tied very closely with James and Keith's teams, matching resources to projected sequential volume return, and we are ready and prepared for additional waves of COVID. With that, I will turn it over to James.

Thank you, Rob. Like all Class I railways, we saw a significant decrease in demand related to the pandemic. At the same time, thanks to our unique geographic reach, we set all-time record in the quarter for Canadian coal, Canadian grain, West Coast propane, and wood pellets. Prince Rupert gives us a structural advantage that cannot be replicated and creates supply chain resiliency that helps our customers win in their end markets in good times and bad. We set new records for grain for the last four consecutive months. Our customers have invested heavily in new country elevators on CN and new export capacity in Vancouver. In order to support these investments, we will be acquiring 1,500 additional high-capacity hopper cars for 2021. That would create the capacity for us to continue to set new records for Western Canadian grain through next year. These new high-capacity cars allow us to ship up to 20% more wheat and 40% more canola using the same train resources, creating an overweighted benefit for CN, given the commodity mix of our business. Wood pellets in particular was a good news story in Q2. Our year-over-year volume growth of about 15% has come from expansion projects across British Columbia and Alberta with more production coming online through the end of 2020. We set an all-time record for West Coast export propane volume in the second quarter and reached a new sustainable run rate of 70 cars per day, working with our partners Altagas and Ridley Terminals. The CN Prince Rupert supply chain offers propane producers access to the best netback markets in Asia, and we expect to see continued growth in West Coast propane exports via Prince Rupert through the balance of this year and next, as Altagas continues to set new records and Pembina starts up their new facility early in 2021. Coal unloads at Ridley terminals of 3.2 million tons for the quarter was an all-time record as well. West Coast coal volume was up over 22% in Q2 compared to the previous year. There is a slow sequential recovery in our manifest franchise, and we expect that May was a low watermark for our carload business. Our lumber franchise in particular started to recover late in Q2 with commodity pricing improving by around 40% from April to June. We expect to see sequential growth for the balance of the year and are now seeing demand at pre-COVID levels. The crude oil price war and demand disruption caused by the pandemic severely impacted our crude, frac sand, and fuels business much more than our general manifest and bulk business. We're seeing demand come back for diesel, ethanol, and frac sand with sequential growth from Q2 into Q3. We continue to invest in lockstep with our customers to facilitate carload growth. This is made possible by our continued ability to price ahead of railway cost inflation across all business units at CN. I'll now turn it over to Keith.

Thanks, James. The reach and scale of our network and the variety of products and services that we offer have allowed our consumer businesses to be resilient in the face of volatile demand. The acquisitions of H&R and TransX have amplified our industry-leading refrigerated services. This allowed us to grow in the consumer and grocery freight weights that we saw in Q2. CN’s wholesale partners were also able to drive growth in these segments. Our Q2 overseas business fared well in the face of lowered consumer demand and significant transpacific blank sailings by the ocean shipping industry. We see significant volumes for July and August on the West Coast. And Prince Rupert could see a record in July, as carriers reinstitute vessel calls previously scheduled for blanking in Q3. We also see additional vessels being scheduled for ad hoc service as containers sitting on the docks in Asia require more capacity. Strong customer relationships and our extensive network reach have helped CN to win a large portion of these reinstituted and ad hoc vessel calls for Q3. Grain records were not only set in James' carload segment, in June we moved 60% more containerized grain versus Q2 of last year. The success of the grain container terminal in Regina has been a great addition to the network. Our CSX steel wheel interchanges from the ports of New York, New Jersey, and Philadelphia sequentially grew in Q2. In automotive, we are now seeing a welcomed rebound in volumes with the majority of the plants we service continuing to produce during what would otherwise be the traditional summer shutdown. As JJ said, we're focusing on the long term, even as we deliver results during challenging times. We're focusing on costs, rightsizing resources and assets in our multimodal operations. Initiatives are underway in intermodal terminals, our auto ports, as well as our subsidiary operations. Our supply chain partners continue to invest in the long-term future of our ecosystems. For example, in Vancouver DP World center is bringing on more rail capacity as we speak. And in Halifax, the Super-Post-Panamax crane was delivered to PSA a few weeks ago. CN’s reach and network scale, the diversity of service offerings and the structural and capacity improvements that we and our supply chain partners are implementing will produce mid to long-term growth from the consumer businesses. I'll now pass on to Ghislain for the financial perspective.

Yes. Thanks, Keith. Overall, the point I'd like to make is that our strong balance sheet and disciplined cost management allowed us to manage well during a challenging time, while continuing to invest for the future. Starting on page 12 of the presentation, I will summarize the key financial highlights of our second quarter performance as we continue to provide essential services to move the North American economy. Revenues for the quarter were down 19% versus last year at just over $3.2 billion. As part of our continued efforts on PSR and asset rationalization, we recorded a non-cash charge of $486 million in the quarter, resulting from the decision to market for sale certain non-core lines for ongoing rail operations. Our adjusted operating ratio is 60.4%, up 290 basis points versus last year. Adjusted net income was $908 million or $342 million lower than last year, with adjusted diluted EPS of $1.28, down 26% versus last year. The impact of foreign currency was favorable by $13 million on net income in the quarter or $0.02 of EPS. Turning to page 13, let me highlight a few of our key expense categories on a constant currency basis. Labor and fringe benefit expense was 18% lower than last year. Overall headcount at the end of the second quarter was down 5,100, a 19% decrease year-over-year. Purchased services and material expense was 11% lower than last year. This was mostly the result of lower outsourced services, trucking and transload, and material expenses. Fuel expense was 49% lower than last year, driven by a 39% decrease in price, 20% lower workload, and an all-time record fuel efficiency. Now, moving to cash on page 14. Despite a very challenging demand environment, I'm extremely pleased that we generated over $1 billion of free cash flow in the quarter and close to $1.6 billion through the end of June, nearly double the amount generated for the same period last year. We are the best railroad to go through this unprecedented pandemic with the highest investment-grade credit rating in the industry. And in late June, Moody's reaffirmed CN’s credit rating of A2 with a stable outlook. In fact, our leverage in terms of adjusted debt to adjusted EBITDA at the end of June was lower versus what we reported at the end of Q1. We have plenty of liquidity. And we continue to issue commercial paper at rates lower than LIBOR. We opportunistically priced on April 29, a $600 million 30-year bond at a coupon of 2.45%, the lowest rate achieved by a Class I railroad and the second lowest ever by any corporate in the U.S. debt capital markets. The Company will continue to pause its share repurchases in these economic circumstances and will reassess on an ongoing basis. Let me finish by saying that as you know, we withdrew our guidance for the year on our last earnings call. We are still not providing guidance at this time, which is consistent with most companies in North America. Our scenario analysis for free cash flow that we provided in Q1 still holds. So, to sum up, during this quarter from a financial perspective, we have clearly demonstrated the resiliency of our franchise, delivering value to our long-term shareholders. On this note, back to JJ.

Thank you, team, and thank you, Ghislain. Let me wrap this up before the Q&A. So, as we speak here, our operations are fluid, volume is sequentially slowly improving, and we are carefully recalling some train crews and about to resume some training for the 2021 demand. As we look ahead, we remain bullish, and we also have a culture of resiliency. This quarter should give you no doubt that we are ready for anything. Whether or not the world goes back to normal in six months or we have a prolonged pandemic, we have the team to get this done. With that, Patrick will now take it over to get questions. Thank you.

Thank you. The first question is from Fadi Chamoun from BMO. Please go ahead.

Good afternoon. Thanks for taking my question here. Just quickly, if you can give us some insights into the yield and the petroleum and the materials segment were up 23%, what's kind of behind this? And if you can maybe help us identify whether there were liquidated damages on the crude by rail business and kind of how should we think about the rollout of these liquidated damages as we go into 2021?

Yes. I think James will put that in more detail. But broadly speaking, I'm not sure exactly what data you're referring to, but we are collecting liquidated damages, and it's going into revenue. So, James?

Yes. Fadi, you’ll recall, when we got back into the crude by rail segment in 2018, securing long-term contracts with associated liquidated damages that pay out over the life of the contract. So, these payments come in, kind of every month, every quarter until these contracts run out or hopefully, the customer starts shifting at their prescribed contract levels. On the yield mix question, Fadi, what were you driving out there? Maybe provide more...

I'm just looking at the freight revenue per RTM that you've reported for the petroleum and metals and minerals that were up pretty significantly on a year-over-year basis. So, what's kind of behind those increases that you had in the quarter?

Well, we had a significant change of mix on the frac sand and crude oil side. These tend to be very, very long haul moves, very heavy RTM moves that just are not with us at this time primarily because of the crude oil price crash associated with the demand disruption and COVID.

Yes. So, we're not doing as much crude, we're not doing as much as long haul crude, nor doing as much frac sand. And we're still collecting the take or pay portion of some of that contract commitment customers made with us hope. Hopefully this helped you with your question, Fadi?

Yes. Thank you.

Thank you.

Thank you. The next question is from Ravi Shankar from Morgan Stanley. Please go ahead.

Thanks. Good evening, everyone. JJ, international intermodal has really been a growth engine for the Company for the last several years. Can you help us to understand how you're thinking of near-shoring as a potential maybe risk to the growth of international intermodal over time? How does CN and your port partners kind of continue to add value? And maybe if you can share what kind of discussions you're having with your shipper customers on potentially moving their supply chains to North America?

Okay. So, let me start. We are very bullish on the strength of the consumer in North America, even more so on the consumer living in the U.S. in a big city because we have a three-coast network and we can access some of the highly populated areas. The consumer disposable income is really key to CN’s future. And the product that's most suited to exploit the consumer spending and disposable income is intermodal. The business coming by the port is definitely one of our mid to long-term strategies to increase our business in that space, in two ways. One is to try to earn market share. It is a North American market. The border does not exist when it comes to supply chain. Therefore, we're looking to outperform that economy, which would perform better as it relates to the part of the GDP that's related to the consumer and play a big role in the U.S. market, competing hard with East Coast and West Coast railroads and East Coast and West Coast ports. I don’t know if you want to add some color to some feedback you're getting from the specific customers, Keith?

Sure. Those that supply their needs, whether it’s retail or manufacturing in North America, they've been looking not only to China over the years, but they've also been sourcing products from Southeast Asia, and that is still growing. Those plants are still being built. What we're seeing is the farther south you go, the more economically feasible it is to maybe go through the Suez Canal and then go to the East Coast. That is one of our strategies, as you know, is the three-coast access that we have at CN, which is unique and does not exist with any other railroad. That is why we have the strategies in place for Halifax, Quebec City; that's why we see all of these infrastructure projects on the East Coast for us as risk mitigation and as an aggressive standpoint to attract that business to North America through the gateways that we service on our three coasts.

So, maybe to wrap this up, Ravi, to answer your question directly regarding near-shoring. The reality is that they will be in-country sourcing for all this stuff that's deemed to be essential for a country, medical devices, eventually vaccines and anything related that's purchased by a government who is going to be willing to pay more for those goods that are essential at this time. But, when it comes to consumer products, it's still going to be quality and price. The consumer is going to look at the price tag first, number one; the quality second, number two; and the country of origin, maybe sometime, and maybe most of the time, probably not. Near-shoring of day-to-day consumer goods, especially the lower value ones, that's not going to happen. But, if it's very high-value goods that are electronic or a computer chip, yes, you could do that because the labor cost is key. Remember, the U.S. dollar is very strong, and that's a challenge to bring manufacturing back to North America.

Thank you. The next question is from Cherilyn Radbourne from TD Securities. Please go ahead.

Thanks very much. Good afternoon. So, on your Q1 conference call, we talked about how at that time you were recalibrating resources weekly and in some cases even twice a week. I was just curious whether that's still the case, or whether at this stage shippers are able to give you a bit more visibility than that?

Rob is on top of that, Rob?

Yes. We continue to be very tight with James’ and Keith’s teams in terms of the expectations out there. That has been part of our success here in the second quarter and how we've been able to quickly right-size our resources. We are doing it weekly, biweekly in terms of keeping our employees cut in that are on furlough. As far as our locomotives, we did that with a purpose. As we laid up locomotives, we laid up the least reliable, and we laid them up in places where we could get to them quickly. So, we remain very tactical throughout this, Cherilyn, and we're ready for whichever way it may go here.

If I may add to what Rob said. In June, we pulled cars out of storage for the automotive sector when we recalled some crews in Michigan. As we speak in July, the lumber business has picked up, and we're calling back crews for the lumber geographic market and putting cars in service. The business on Rupert right now is very strong. That's another area where we have been recalling some crews selectively. We are very mindful of the cost, but at the same time, we are an enabler of the economy; we're an enabler of the recovery. When some of these segments start to come back, we need to be there for them, and we are.

Great. Thank you for your time.

Thank you.

The next question is from Ken Hoexter from Bank of America. Please go ahead.

JJ, could you share your thoughts on the employee situation? You're down 5,100 compared to last year. What are your views on how to increase that number sequentially? Additionally, the cost per employee remained flat year-over-year. Were there any significant one-time costs you held back on this quarter that we should expect moving forward? Can you also discuss the pace of return costs? Thank you.

Rob?

Yes. Since our low, we saw the trough in terms of volumes in late May, and that's really where we spiked or saw our most employees on furlough. As we got into the summer season with vacations and also an increase in volume, we selectively called back employees. But it's not on a one-to-one basis as volumes come back in. We are very methodical about bringing them back, especially as we go into the third quarter. Just as Ghislain talked about, we're still trying to figure out what the future volume is going to be. So, we're very, very careful with all of our assets, not just employee resources, but also our locomotives and cars as well.

Yes. Some of the differentials are related to furloughs that we hope will eventually return to work, while others are permanent and not furloughed. Therefore, we have not furloughed over 5,000 people; it's closer to 3,000.

And your thoughts on the cost front?

Could you say that again?

Regarding costs, can you share your thoughts on the cost per employee, which remained unchanged? I would like to know if there were any one-time expenses that were excluded during the quarter but are expected to return as we progress through the rest of the year.

Ghislain, do you have any color on that?

Well, there's a bit of incentive compensation that created the benefit in the quarter, Ken. Maybe that's because when you look at employee expenses and when you look at inflation, it's still running around 2% wage inflation. But there is some benefit related to incentive compensation that has provided some benefits in the quarter.

Thank you. The next question is from Chris Wetherbee from Citi. Please go ahead.

Just kind of curious, if you could give a little bit more color on the line sales you announced. And then, maybe if you think forward, if they're non-core, maybe what that might mean from a cost savings perspective, would this be accretive from an OR standpoint as we go into the back half of the year?

So, they are non-core. Ghislain, do you want to pick that up? You've worked on that project pretty much.

Yes, they are non-core. As you recall, we rationalized our network in Canada years ago, but we've not done the same in the U.S. These non-core lines came with our acquisition of WC. They mainly include non-core lines in Wisconsin, Michigan, and Ontario. Given the cost structure of smaller operators, which aren’t like a Class I railroad such as ourselves, and their occasional access to government funding, they will likely be better suited to operate these lines. These lines will keep feeding into our main line, benefiting our long-haul operations. Regarding the operational ratio benefits, this is a positive step. As you know, part of the Precision Scheduled Railroading (PSR) strategy involves rationalizing parts of the network. More efficient operators can handle some non-core lines better than we can while still ensuring the line-haul business continues to flow to our main line. We are quite excited about this as it demonstrates our commitment to advancing PSR on all fronts.

Yes. It's on the fundamental of making sure we have a network that has a capital call where it's needed. In some cases, a short line operator could actually get capital from the state, province, or government, which we don’t have access to. So, it's a better model for those non-core lines that we're selling.

Thank you. The next question is from Benoit Poirier from Desjardins Capital. Please go ahead.

Good afternoon. Could you maybe provide some color on the latest question with respect to the potential proceeds for the assets, and whether you would use the amount to buy back some shares or any thoughts about the proceeds?

Ghislain?

Yes. I mean, listen, we're going to try to get as much as we can for these lines. Obviously, we’re hiring bankers to help us market them and so on. I’m not going to lay out what we expect because again, we're going to shoot ourselves in the foot when we auction these lines out if we disclose what we get for them. Hopefully, we get a good amount. We will get what they're worth. Then, we'll see what we do with the cash. Our use of cash policy doesn't change at CN, as you know. The first use of cash is towards the business, and then we'll look at shareholder distribution first and foremost, dividend. I'm quite proud of our 7% dividend growth this year. I'm quite proud of the consistency of our dividend, which is a 16% CAGR since we privatized. We've also used share buyback to get to a target leverage level because this is the flexible tool. When cash comes, we will figure out what we do, but our use of cash strategy remains the same.

That's right, which is investing in the business, dividend, and share buyback.

Thank you. The next question is from Scott Group from Wolfe Research. Please go ahead.

So, you had a slide with some structural cost changes. Any way to quantify how much that is? And then, on the yield side, yields overall were down. Any way to think about some of the moving pieces for the third quarter on either revenue per car load or revenue per RTM?

So, maybe Rob can provide some insights into where we anticipate a permanent reduction in our costs. Regarding the RTM question, perhaps Ghislain can elaborate on that. Let's start with Rob.

Yes. Thanks for the question, Scott. I mentioned some of that in my opening comments in terms of some of the shops and some of the yards that will remain closed. We don't anticipate those being opened back up. In terms of locomotive fuel efficiency, of course, I quantified that in there in terms of what we got on the quarter. We will continue to see record fuel efficiency here with some of the measures we have in place. The train design in terms of what we're doing with train length and train weight, that'll continue. We'll continue to see those improvements year-over-year into the quarter. So, those are some of the structural changes we're looking at and we see that continuing here for the near future.

Yes. I think Scott, in terms of cent per RTM, I think we're not going to provide guidance on cent per RTM on a quarterly basis. But all I can tell you, we don't necessarily manage the business on cent per RTM. The mix that we have is the mix that we deal with. What we manage is price, and we're quite good. Keith and James and their teams have done quite a good job actually to manage price. The price that we're getting is still above rail inflation. It's solid pricing. We continue that way. You can expect that to continue in the third quarter and the fourth quarter and going forward.

That's correct. Some of the changes will be lasting. In June specifically, our mix shifted significantly because the automotive business, which is lightweight and high revenue, almost vanished, creating a noticeable impact on our overall business. This led to a distortion between gross ton miles and revenue ton miles, affecting our business mix. What's crucial for us is to ensure that every carload is profitable. We assess that through the revenue to cost ratio, which is essentially the inverse of the operating ratio. Regarding pricing, we don’t focus on cent per RTM because that metric tends to reflect noise, changes in mix, and haul length. I provide the car while the customer provides the car. The key factor in pricing is same store price, similar to how retailers evaluate their sales compared to the previous year. Anything that doesn't qualify as a same-store sale isn't included in the same store price calculation as it doesn't offer a comparable basis. Many of these different sales significantly affect the cent per RTM metric, which is why we prioritize same store sales and the revenue to cost ratio instead.

The next question is from Konark Gupta from Scotiabank. Please go ahead.

Thanks. Good afternoon. My question is just going back to your previous target for operating ratio that you discussed at the investor day before. How do you think about the operating leverage and capital intensity heading into 2021, as volumes recover further and you bring back more employees and pull out some fleet from storage?

Currently, we have capacity on our network that we developed over the past two years. We could have utilized this capacity this year if not for the economic challenges and the pandemic. We have the potential for growth and have qualified personnel ready to maintain equipment, repair locomotives, and operate trains; unfortunately, many of these individuals are currently on furlough, but we aim to bring them back. As we improve our efficiency, with factors like train weight reducing the number of personnel needed per ton mile, we can achieve substantial savings. Our approach to operating ratio is not about being the lowest or the worst; instead, we aim for a cost-competitive ratio that supports organic growth alongside our customers as they present us with business opportunities. Rob, would you like to share your thoughts on operating ratio?

Yes. In terms of operating leverage going forward here into the third quarter, I mentioned some of the things we're doing and will continue to do. We're not bringing back resources on a one-to-one basis. That will continue to provide benefits for us. When you go through a quarter like we did, we’re able to test and really press the edges of what we're capable of, and we found some of these opportunities through that process. Again, I talked about fuel efficiency, train length. These are things that when you talk about sending records at CN, that's saying something, right? This is a storied, long storied history of operational excellence. When you start to set records, and we set a number of them here in the second quarter, that really speaks to the teams, to the operating model. We've done a nice job and we continue to leverage that here going into third quarter.

Yes. Competitive operating ratio, but focus on business growth and focus also on inorganic growth, things beyond just rail but things that would be credited to rail. That's why we have made some acquisitions and joint ventures.

The next question is from Brian Ossenbeck from JP Morgan. Please go ahead.

A question for Rob on the technology and the operating side. Can you give us an update on the inspection cars? It looks like you're moving to Phase 2 under the FRA next month with some reductions on visual inspections, you got Transport Canada on board. It looks like growing up through some subdivisions. So, can you just give us an update on how this is progressing relative to patience? At what point do you think you'd be able to quantify some of the benefits, either from an accident reduction perspective, workforce perspective, or even capacity additions in the future?

Very timely question. Rob, do you want to…

Yes. I'd love to take that one. Thank you for the question. We continue to make progress. Just as you talked about, in the U.S., we have a pilot program going on with the FRA. We are transitioning to Phase 2 as we go into August. What that will mean is 50% less manual inspections. That’s all around our autonomous track inspection program. It's really about having a safer, more reliable network, it does reduce costs, and it unlocks capacity on our network by embedding these in revenue service trains versus having a human being on the track. In terms of quantifying it, we've seen our train accident ratio down 22% year-over-year. Certainly, some of that can be traced back to that. We tested the line in the U.S. 17 times more than traditional testing right now. Strengthening the line turns our employees into fixers versus finders, all of that is coming true. In Canada, we're starting to see the results of our work with Transport Canada. We do have an exemption there to begin testing, and we'll continue to follow the same pattern that we had in the U.S. This makes us safer, provides a more reliable network. We see costs fall out just from the safety aspects of it, and it does unlock capacity as we go on.

It is sequential, and you're going to hear from us in the months to come that we're adding resources. We want to help Rob with top-tier talent as to how we implement and roll out technology for the rail operations. So, more to come on that.

Thank you. The next question is from Walter Spracklin from RBC Capital Markets. Please go ahead.

Good afternoon, everyone. Regarding incremental costs, you did a commendable job of managing expenses this quarter. The operating ratio decline was less than 300 basis points. I'm curious about your cost management efforts, which likely improved over the quarter. As you finished the quarter, can we assume that your ability to mitigate the operating ratio impact from ongoing volume declines in the third quarter will be moderated? Should we expect to not see a degradation in the operating ratio, or do you anticipate some level of degradation as we progress through the quarter, especially when excluding the fourth quarter's strike issue and focusing on the third quarter?

Ghislain, you're looking at your crystal ball…

Yes. I can look at my crystal ball, Walter. First of all, what we do on costs and what the team did, to your point, in the second quarter, is quite remarkable. We have some headwinds that are quite fixed that we have to deal with. I've mentioned that at the beginning of the year. We have about $130 million of depreciation that we have to deal with. We also used to have $70 million on pension. Now with the betterment in pensionable payroll, it's down to 50, but it's still 50. So, we have $180 million of headwind. If you slice that every quarter, this is cost that we have to deal with. So, I think the proof will be in the pudding in Q3. As you know, and JJ made the point, we've never been enamored with OR at CN. I think we'd rather be a $20 billion, 60% OR than a $15 billion at 59. Just do the math. At the end of the day, we will continue to manage costs, and we manage both the short-term and the long-term. We will make decisions to ensure our report cards come out every three months, and that the report card will come out in October. You’ll look at the OR and all of the metrics. We're making decisions to make sure we're well prepared for winter coming. Whether we like it or not, we have a winter in Canada and for 2021. So, stay tuned. I didn’t really answer your question on how the OR will look, because I'm not. But we're very pleased with our OR in Q2 and I'm telling you to stay tuned for Q3.

Depreciation presents a short-term challenge due to the capital program we executed over the past two years, but it also indicates our capacity to manage significantly more business. This challenge will eventually transform into our growth potential alongside the economy as it improves or as we develop products and expand our market share. This outlines our focus for 2021. James has introduced a program regarding the grain that will see most railcars built between now and Christmas, with deliveries to CN scheduled for the first 15 days of January. These will generate revenue next winter.

Thank you. The next question is from Brandon Oglenski from Barclays. Please go ahead.

Thank you for taking my question. Keith, you sounded, I should phrase it, relatively bullish about intermodal prospects looking into, I guess, peak season. Can you talk about growth opportunities? You mentioned in your prepared remarks about carriers adding back rotations and that you're winning some of that incremental business.

Sure. As I said earlier, we believe in the strength of the consumer in North America, and the markets where that shows the most number one is intermodal. You see that a bit in lumber and locomotives, but where this is something to really exploit, whether the product is really tailored to drive the consumer economy, has intermodal. Keith?

Sure. The beginning of the second quarter was challenging as we dealt with blank sailings and the difficulties our customers faced, and I was concerned this would carry into the third quarter. However, it's encouraging to see that many of the blank sailings for Q3 have been reinstated. Currently, there is significantly less disruption related to blank sailings on the West Coast compared to Q2. In fact, they're adding 11 extra loaders in Q3 on the West Coast, 9 on the West Coast, and 2 on the East Coast. These developments, along with insights from our team in Asia regarding order strength from North America, boost our confidence. I feel comfortable discussing preparations with Rob. Rupert is likely to achieve a record in July, and we anticipate similar strong volume for August on the West Coast.

There is a surge from the retailer, which is reflecting back in shipping lines and into port activities into a different consumption, which I would call stay-at-home consumption. People are building a deck, renovating their house, painting, spending money in their backyard, putting in a pool. This stay-at-home expense around the house and on the backyard is quite evident. We see this in the supply chain. Some are out of whack, while some are full because of people don't want to buy certain items. Some warehouse relating to the stay-at-home expense are empty. You try to get a barbecue, and you may not quite get the kind that you're looking for; you're just going to have to buy whatever is left at Home Depot. We’re seeing some of that too—some containers need to move fast due to the change in consumer spending.

Thank you. I would like to turn the meeting back over to Mr. Ruest.

Thank you, operator. Thanks for joining us today. I just want to use some closing comments. We're very proud of our end-of-quarter results here. The team has been able to do the best of what came out as very quickly. We kept everybody safe. We unfortunately had to do quite a few layoffs. The good news is, we've started recalling some people back to work. We are getting some assets back in the business. You see from our cars at RTM that there is some sequential growth. We'd love to see more of it. But, we'll track the economy. In the meantime, Rob is working hard on costs, and we're staying focused on long-term business. I mentioned the work that we do on strategy and the work that we're doing with initiatives related to organic growth. Stay tuned. CN is ready for anything, whether we have a slow recovery, a second wave of pandemic, or a better business outlook come October-November. We will see. Thank you for joining us today. This is the end of the call. Thank you, Patrick.

You're welcome. The conference has now ended. Please disconnect your lines at this time, and thank you for participation.