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, 2008
Business Overview: CN operates a Class I railroad 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 "precision railroading" to improve velocity, reliability, and asset utilization.
Key Financial Metrics
| Metric (C$ Millions) | Q1 2008 | Q1 2007 | Change |
|---|---|---|---|
| Revenues | 1,927 | 1,906 | +1% |
| Operating Income | 523 | 561 | -7% |
| Net Income | 311 | 324 | -4% |
| Diluted EPS | $0.64 | $0.63 | +2% |
| Operating Ratio | 72.9% | 70.6% | +2.3 pts |
| Operating Expenses | 1,404 | 1,345 | +4% |
| Cash from Operations | 165 | 263 | -37% |
| Free Cash Flow (Non-GAAP) | 61 | (176) | Improvement |
Liquidity and Debt:
- Cash and cash equivalents: $334 million (March 31, 2008).
- Total long-term debt: $6,064 million.
- Current portion of long-term debt: $269 million.
- Debt-to-total capitalization ratio: 38.6%.
Material Changes vs. Prior Period
- Revenue Drivers: Revenues increased 1% primarily due to freight rate increases (including higher fuel surcharges), improved traffic mix, and volume growth in grain, fertilizers, and intermodal. These gains were offset by the negative translation impact of a stronger Canadian dollar (approx. $150 million impact on revenues) and lower volumes in forest products and automotive sectors.
- Expense Pressures: Operating expenses rose 4% to $1.404 billion. The primary driver was a 42% increase in fuel costs due to higher average fuel prices. Labor and fringe benefits decreased 5% due to the favorable translation impact of the stronger Canadian dollar and lower pension costs.
- Operating Ratio: The operating ratio worsened by 2.3 points to 72.9%, reflecting the combination of modest revenue growth and significant expense inflation, particularly in fuel.
- Comparability Factors:
- Q1 2008: Included a $11 million deferred income tax recovery. Severe winter weather in Western Canada and the U.S. Midwest disrupted operations and increased costs.
- Q1 2007: Impacted by a conductors' strike in Canada, which reduced net income by approximately $35 million.
Guidance, Outlook, and Risks
Revised 2008 Outlook
Based on difficult Q1 operating conditions and market weakness, CN revised its full-year 2008 guidance:
- Diluted EPS Growth: Now expected to be in the mid-single digit range over 2007 adjusted diluted EPS of $3.40 (previously mid-to-high single digit).
- Free Cash Flow: Now expected to be in the order of $650 million (previously $750 million).
- Revenue Growth: Maintained forecast of 6% to 8%.
Key Assumptions: The outlook assumes a Canadian-U.S. dollar exchange rate at or around parity, crude oil prices around US$105/barrel, and North American economic growth of approximately 1%.
Management Commentary
CEO E. Hunter Harrison noted that severe weather and a strong Canadian dollar depressed Q1 performance. However, the company is making steady progress in network fluidity. Management remains cautious about the North American economy, anticipating a gradual recovery in the second half of 2008. Growth opportunities are identified in container trade via Prince Rupert, resource demand, and oil/gas development in Western Canada.
Risks and Contingencies
- Regulatory: Pending approval from the Surface Transportation Board (STB) for the acquisition of Elgin, Joliet and Eastern Railway Company (EJ&E) for approx. US$300 million. An Environmental Impact Statement is required.
- Operational: Exposure to severe weather, fuel price volatility, and labor negotiations (though agreements are currently in place for the Canadian workforce).
- Legal/Environmental: Significant accruals for personal injury claims ($458 million) and environmental costs ($109 million). Future liabilities related to environmental remediation cannot be precisely estimated.
Investor Verification Checklist
- Weather Impact: Verify the extent of operational recovery following the severe Q1 2008 winter weather in Western Canada and the U.S. Midwest.
- Currency Sensitivity: Monitor the Canadian-U.S. dollar exchange rate, as a stronger CAD significantly reduces reported net income and revenue from U.S. operations.
- Fuel Costs: Track diesel fuel prices and the effectiveness of CN's fuel surcharge program in offsetting rising costs.
- Market Segments: Assess the recovery of forest products and automotive volumes, which were significantly down due to U.S. housing market weakness and customer labor issues.
- Acquisition Status: Monitor the STB approval process for the EJ&E acquisition and any associated environmental conditions.
- Capital Expenditures: Verify adherence to the $1.5 billion capital program for 2008, specifically regarding track infrastructure and strategic initiatives.