UPDATE 2-CN Rail profit sags 13 pct but says worst is over

* Q3 EPS C$0.94 vs forecast C$0.89

* Economic downturn has hit bottom, CEO says

* Strong C$, fuel prices could hurt Q4

* Deal with union could be close (Recasts with comments from company conference call)

VANCOUVER, British Columbia, Oct 20 (Reuters) - Canadian National Railway (CNR.TO) (CNI.N) reported a better than expected 13 percent drop in third-quarter profit on Tuesday as deep cost cuts helped cushion the impact of the recession.

Executives at Canada's biggest railroad repeated cautiously upbeat comments made in recent months that the worst of the economic downturn was over, but also pointed out there would still be economic head winds.

"I think we have bounced across the bottom and now we are starting to float to the top," said Chief Executive Hunter Harrison, speaking on his final results conference call before he hands the reins to CEO-in-waiting Claude Mongeau on Jan. 1.

However, the recent strength in the Canadian currency against the U.S. dollar could hurt CN's bottom line in the fourth quarter, Chief Financial Officer Luc Jobin said, when the railway's U.S. earnings are translated back into Canadian dollars.

In the same vein, the company won't benefit from the sharp drop in fuel prices it enjoyed in the fourth quarter last year, Jobin said.

A possible near-term positive could be the settling of drawn-out labor negotiations, Harrison said. CN and 1,700 locomotive engineers, represented by the Teamsters union, are still without a contract after their last one expired at the end of 2008.

"The two sides are not far apart ... both sides want to reach an agreement," Harrison said, adding that there could be "good news" possibly in "a week or so, or two".

EARNINGS TOP ANALYST EXPECTATIONS

CN said net income adjusted for various tax issues fell 13 percent to C$446 million ($439 million), or 94 Canadian cents a share, in the three months ended Sept. 30, from C$511 million, or C$1.07 a share, a year earlier.

Revenue fell 18 percent to C$1.85 billion.

Analysts had expected a profit of 89 Canadian cents a share on revenue of C$1.95 billion, according to Thomson Reuters I/B/E/S.

CN, which has lines across Canada and into the United States, cut operating costs by 18 percent to C$1.16 billion during the quarter.

Revenue ton miles, a measure of the relative weight and distance of freight transported, was down 11 percent from the year-ago period, while carloads fell 15 percent.

In July, Montreal-based CN reported a 16 percent drop in quarterly profit, but forecast a better performance in the second half of the year versus the first six months.

CN shares ended at C$55.04 on the Toronto Stock Exchange on Tuesday, up 0.55 percent. Year-to-date, the stock has gained about 15 percent.

($1=$1.05 Canadian) (Reporting by Nicole Mordant and Susan Taylor)