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, 2007
Release Date: July 23, 2007
CN is a major North American railroad spanning Canada and the mid-United States. The reporting period was characterized by operational challenges including a flood-induced shutdown of the Prince Rupert line, illegal blockades on the Toronto-Montreal main line, and a first-quarter strike by the United Transportation Union (UTU). Additionally, the company faced a sharp appreciation in the Canadian dollar against the U.S. dollar and continued weakness in the forest products sector.
Key Financial Metrics
| Metric (C$ Millions) | Q2 2007 | Q2 2006 | 6M 2007 | 6M 2006 |
|---|---|---|---|---|
| Revenues | 2,027 | 2,000 | 3,933 | 3,897 |
| Operating Income | 811 | 805 | 1,372 | 1,430 |
| Net Income (GAAP) | 516 | 729 | 840 | 1,091 |
| Adjusted Net Income | 486 | 479 | 810 | 841 |
| Diluted EPS (GAAP) | $1.01 | $1.35 | $1.63 | $2.01 |
| Adjusted Diluted EPS | $0.95 | $0.89 | $1.57 | $1.55 |
| Operating Ratio | 60.0% | 59.8% | 65.1% | 63.3% |
| Free Cash Flow | 227 | 422 | 51 | 740 |
Liquidity and Debt: Cash and cash equivalents stood at C$241 million as of June 30, 2007. Total debt (current and long-term) was C$5,559 million. The debt-to-total capitalization ratio was 36.2%.
Material Changes vs. Prior Period
- Earnings Volatility: GAAP net income decreased significantly year-over-year in Q2 (C$516M vs C$729M) and 6M (C$840M vs C$1,091M). This decline is primarily due to a large deferred income tax recovery of C$250 million in Q2 2006, compared to only C$30 million in Q2 2007.
- Adjusted Performance: Excluding tax recoveries, adjusted diluted EPS increased 7% in Q2 (C$0.95 vs C$0.89) and 1% in the first half (C$1.57 vs C$1.55).
- Revenue Drivers: Revenues increased 1% in both Q2 and 6M periods. Growth was driven by freight rate increases, improved traffic mix, and volume growth in petroleum, chemicals, automotive, and grain/fertilizer sectors. These gains were offset by a stronger Canadian dollar, lower fuel surcharge revenues, and weakness in forest products.
- Operating Expenses: Expenses rose 2% in Q2 and 4% in 6M, driven by higher equipment rents, fuel costs, and purchased services. This was partially offset by lower casualty expenses and labor costs.
- Strike Impact: The Q1 UTU strike reduced first-half operating income by approximately C$50 million and net income by C$35 million.
Guidance, Outlook, and Risks
Guidance Revision: CN lowered its full-year 2007 earnings guidance. The company now expects adjusted diluted EPS growth of approximately 5%, down from a previous forecast of 10% or more. This outlook assumes accelerating economic growth in North America in the second half, crude oil prices settling around US$70/barrel, and a C$/US$ exchange rate of approximately US$0.95.
Management Commentary: CEO E. Hunter Harrison noted strong performance in automotive, petroleum, and grain sectors despite challenges. The company anticipates stronger intermodal volumes following the October start-up of the new Prince Rupert container terminal.
Risks and Contingencies:
- Operational Disruptions: Risks include severe weather, floods, and labor disruptions.
- Legal and Environmental: The company maintains C$520 million in reserves for personal injury and other claims, and C$117 million for environmental costs. Future liabilities related to environmental remediation cannot be reasonably estimated.
- Market Conditions: Continued weakness in specific segments (e.g., forest products) and currency fluctuations remain key risks.
Investor Verification Checklist
- Adjusted vs. GAAP Earnings: Verify the impact of the C$30 million deferred tax recovery in 2007 versus the C$250 million recovery in 2006 to understand the true operational trend.
- Strike Impact Quantification: Confirm the C$50 million operating income reduction attributed to the Q1 UTU strike.
- Exchange Rate Sensitivity: Assess the impact of the strong Canadian dollar on U.S. dollar-denominated revenues and the validity of the US$0.95 exchange rate assumption in the guidance.
- Share Repurchase Program: Note the completion of the previous 28 million share program and the approval of a new 33 million share repurchase program on July 23, 2007.
- Free Cash Flow Decline: Investigate the significant drop in free cash flow for the six-month period (C$51 million in 2007 vs C$740 million in 2006), driven by changes in accounts receivable securitization and higher capital expenditures.