CNI

Business Context and Reporting Period

Company: Canadian National Railway Company (CN)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: First Quarter ended March 31, 2013
Business Overview: CN operates a transcontinental railway network spanning Canada and the mid-section of the United States, connecting the Atlantic and Pacific oceans to the Gulf of Mexico. The company reported financial results for Q1 2013, highlighting operational challenges due to extreme weather in Western Canada.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Revenues increased 5% year-over-year, driven by a 2% increase in carloadings and a 3% increase in revenue ton-miles. Freight rate increases contributed to a 2% rise in revenue per revenue ton-mile.
• Profitability Decline: Reported net income decreased significantly from C$775 million to C$555 million. This decline is primarily attributed to a reduction in one-time gains from the sale of rail line segments (C$36 million after-tax in 2013 vs. C$252 million after-tax in 2012).
• Adjusted Performance: Excluding rail line sale gains, adjusted net income increased to C$519 million (C$1.22 EPS), a 3% improvement over the adjusted C$523 million (C$1.18 EPS) in Q1 2012.
• Operating Ratio Deterioration: The operating ratio worsened by 2.2 percentage points to 68.4%, reflecting a 9% increase in operating expenses (labor, fuel, purchased services) outpacing revenue growth.
• Cash Flow: Free cash flow turned negative (utilized C$20 million) compared to a positive C$48 million in the prior year, largely due to higher capital spending and dividend payments.

Guidance, Outlook, and Risks

• Capital Spending Revision: CN increased its 2013 capital spending plan to approximately C$2 billion (up from C$1.9 billion). Approximately C$1.1 billion is targeted for track infrastructure to improve network resilience, specifically in the Edmonton-Winnipeg corridor.
• Operational Outlook: Management expects to emerge stronger from Q1 operational challenges (extreme cold/snow). The company anticipates continued strong volume growth and pricing improvements above inflation.
• Economic Assumptions: Outlook assumes North American industrial production growth of ~2%, U.S. housing starts of ~950,000 units, and crude oil prices (WTI) in the range of US$90-$100 per barrel. The CAD/USD exchange rate is assumed to be near parity.
• Risks and Contingencies:
  • Legal/Environmental: Aggregate reserves for personal injury and other claims are C$317 million. Environmental accruals total C$118 million for approximately 300 identified sites.
  • Executive Departures: The resignation of the COO to a competitor resulted in the forfeiture of certain compensation and pension benefits, creating a non-cash gain in the quarter.
  • Weather: Severe weather remains a risk to network fluidity and volume growth.

Investor Verification Checklist

• Adjusted vs. Reported Earnings: Verify the impact of the C$36 million after-tax gain on the sale of the "Lakeshore West" rail segment on reported net income versus the adjusted C$519 million figure.
• Operating Ratio Drivers: Analyze the 9% increase in operating expenses, specifically the rise in fuel costs and labor/fringe benefits, to understand the 2.2-point deterioration in the operating ratio.
• Capital Expenditure Increase: Confirm the allocation of the additional C$100 million in capital spending and its expected impact on future productivity and network capacity.
• Free Cash Flow Utilization: Review the shift from generating to utilizing free cash flow, considering the C$365 million in share repurchases and C$183 million in dividends paid during the quarter.
• Pension Obligations: Note the expected solvency deficit of approximately C$2.0 billion for Canadian pension plans and the company's plan to use accumulated prepayments to fund required solvency payments.