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 First Half ended June 30, 2011
Business Overview: CN operates a rail network spanning Canada and mid-America, connecting the Atlantic, Pacific, and Gulf of Mexico. The company manages its operations as a single business segment, focusing on seven commodity groups: petroleum and chemicals, metals and minerals, forest products, coal, grain and fertilizers, intermodal, and automotive.

Key Financial Metrics

Adjusted Performance (Non-GAAP): Adjusted net income for Q2 2011 was C$578 million (C$1.26 diluted EPS), representing a 12% increase over Q2 2010. This excludes a C$40 million net deferred income tax expense.

Material Changes vs. Prior Period

• Revenue Growth: Q2 revenues rose 8% (11% at constant currency) driven by higher freight volumes, increased fuel surcharges, and rate increases. Intermodal was the strongest segment, with revenues up 14% and volumes up 10%.
• Expense Increases: Operating expenses increased 8% to C$1,386 million, primarily due to higher fuel costs (up 38%), increased purchased services, and higher labor costs.
• Foreign Exchange Impact: A stronger Canadian dollar negatively impacted reported net income by C$14 million in Q2 2011. On a constant currency basis, net income would have been higher.
• Unusual Items:
  • Q2 2011: Included a C$40 million net deferred income tax expense due to state corporate income tax rate changes.
  • YTD 2011: Included a C$288 million gain on the disposal of the Lakeshore East rail property (C$254 million after-tax).
  • YTD 2010: Included a C$152 million gain on the disposal of the Oakville subdivision (C$131 million after-tax).

Guidance, Outlook, and Risks

2011 Financial Outlook:

• EPS: CN expects double-digit adjusted diluted EPS growth of up to 15% for 2011, compared to C$4.20 in 2010.
• Free Cash Flow: Expected to be approximately C$1.2 billion, accounting for a potential C$200 million additional voluntary pension contribution.
• Capital Spending: Plans to invest approximately C$1.7 billion in 2011, with over C$1 billion targeted for track infrastructure.

Management Commentary: CEO Claude Mongeau highlighted solid performance driven by freight volume improvements and operational execution despite weather challenges (floods, fires). The company is applying a new "end-to-end supply chain collaboration" approach, particularly in the intermodal segment.

Key Risks and Contingencies:

• Regulatory: Ongoing oversight by the Surface Transportation Board (STB) regarding the Elgin, Joliet and Eastern Railway (EJ&E) acquisition, including grade separation commitments estimated at C$140 million.
• Environmental: Aggregate accruals for environmental costs were C$132 million. The company faces potential liabilities from approximately 300 sites.
• Legal: Aggregate reserves for personal injury and other claims were C$339 million.
• Operational: Risks include fuel price volatility, labor negotiations (though Canadian agreements were recently ratified), and severe weather disruptions.

Investor Verification Checklist

• Adjusted EPS Reconciliation: Verify the C$40 million deferred tax expense and the C$288 million property disposal gain to understand the difference between GAAP and Non-GAAP results.
• Constant Currency Impact: Assess the sensitivity of future earnings to the Canadian/US dollar exchange rate, given the C$14 million negative impact in Q2.
• Capital Expenditure Execution: Monitor the C$1.7 billion capital plan, specifically the C$1 billion allocation for track infrastructure and the C$193 million Positive Train Control (PTC) implementation cost.
• Pension Contributions: Confirm the final 2011 pension contribution amount, as management indicated a potential additional C$200 million voluntary contribution beyond the expected C$110 million.
• Property Disposal Proceeds: Track the closing of the IC RailMarine Terminal sale (expected Q3 2011) for the anticipated US$73 million proceeds.