CNI

Business Context and Reporting Period

Company: Canadian National Railway Company (CN)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: Second Quarter and Six Months ended June 30, 2013
Business Overview: CN operates a rail network spanning approximately 20,000 route miles across Canada and mid-America, connecting the Atlantic, Pacific, and Gulf of Mexico. The company transports a diversified portfolio of commodities including petroleum, chemicals, metals, minerals, forest products, coal, grain, fertilizers, intermodal, and automotive goods.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Q2 2013 revenues increased 5% year-over-year, driven by a 5% increase in revenue ton-miles and a 2% increase in carloadings. Key growth drivers included strong energy markets (petroleum and chemicals up 18%), market share gains, and a weaker Canadian dollar which positively translated U.S.-denominated revenues.
• Profitability: Q2 Net Income rose 14% to C$717 million. Adjusted diluted EPS increased 11% to C$1.66. However, six-month Net Income decreased 10% to C$1,272 million compared to C$1,406 million in 2012, primarily due to a large one-time gain on property disposal in Q1 2012 (Bala-Oakville) that was not repeated in 2013.
• Operating Expenses: Q2 expenses increased 4% due to higher purchased services, fuel costs, and depreciation. The Operating Ratio improved by 0.4 points in Q2 but deteriorated by 0.9 points for the six-month period due to harsh winter conditions in western Canada impacting Q1 productivity.
• Unusual Items:
  • Q2 2013: Included a C$29 million pre-tax gain on an exchange of easements with another railway.
  • Q1 2013: Included a C$40 million pre-tax gain on the disposal of the "Lakeshore West" rail segment.
  • Q1 2012: Included a C$281 million pre-tax gain on the disposal of the "Bala-Oakville" segment, significantly boosting prior-year comparables.

Guidance, Outlook, and Risks

• Financial Outlook: CN is maintaining its 2013 financial outlook issued in January 2013. The company expects to invest approximately C$2 billion in capital programs for 2013 (revised up from C$1.9 billion), with over C$1.1 billion targeted for track infrastructure.
• Market Assumptions: Management forecasts North American industrial production growth of ~2%, U.S. housing starts of ~950,000 units, and carload growth of 2-3% (revised down from 3-4%). The assumed Canadian-U.S. exchange rate is C$0.95-C$1.00.
• Key Risks:
  • Regulatory: Ongoing inquiries by the Canadian Competition Bureau regarding lumber transportation; potential changes to U.S. economic regulation (STB) and safety mandates (Positive Train Control implementation by 2015).
  • Operational: Labor negotiations with Canadian unions (Teamsters Canada Rail Conference) and U.S. workforce; potential for service disruptions due to severe weather or natural disasters.
  • Financial: Volatility in fuel prices and foreign exchange rates; pension funding requirements (solvency deficit of ~C$2.1 billion identified in Canadian plans).

Investor Verification Checklist

• Adjusted vs. Reported Earnings: Verify the impact of non-recurring gains (easement exchange, property disposals) on reported Net Income versus Adjusted Net Income to assess core operational performance.
• Constant Currency Impact: Review the "constant currency" reconciliation to understand the true operational growth versus the benefit derived from the weaker Canadian dollar.
• Capital Expenditures: Confirm the execution of the C$2 billion capital plan, specifically the allocation to track infrastructure versus rolling stock and facilities.
• Pension Obligations: Monitor the C$2.1 billion solvency deficit in Canadian pension plans and the company's strategy for funding special solvency payments using accumulated prepayments.
• Labor Relations: Track the status of collective agreement negotiations with the Teamsters Canada Rail Conference, which expired in July 2013, for potential strike risks.