Business Context and Reporting Period
Company: Canadian National Railway Company (CN)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: Third quarter and nine months ended September 30, 2006
Business Overview: CN operates a network of approximately 20,000 route miles spanning Canada and mid-America, connecting the Atlantic, Pacific, and Gulf of Mexico. The company transports a diversified portfolio of commodities including petroleum, metals, forest products, coal, grain, intermodal, and automotive goods.
Key Financial Metrics
| Metric (CAD Millions) | Q3 2006 | Q3 2005 | 9M 2006 | 9M 2005 |
|---|---|---|---|---|
| Revenues | 1,981 | 1,810 | 5,774 | 5,354 |
| Operating Income | 844 | 665 | 2,274 | 1,904 |
| Net Income | 497 | 411 | 1,588 | 1,126 |
| Diluted EPS | $0.94 | $0.74 | $2.95 | $1.99 |
| Operating Ratio | 57.4% | 63.3% | 60.6% | 64.4% |
| Free Cash Flow (9M) | N/A | 1,131 | 1,058 | |
| Free Cash Flow (Q3) | 391 | 271 | N/A |
Liquidity and Debt:
- Cash and Equivalents: $56 million (Sept 30, 2006) vs. $119 million (Sept 30, 2005).
- Long-term Debt: $5,164 million (Sept 30, 2006) vs. $4,677 million (Sept 30, 2005).
- Debt-to-Total Capitalization: 36.5% (Sept 30, 2006).
- Revolving Credit Facility: $1,000 million available; $306 million in letters of credit drawn; no outstanding borrowings.
Material Changes vs. Prior Period
Revenue Growth: Revenues increased 9% in Q3 and 8% for the nine-month period. Growth was driven by freight rate increases (including fuel surcharges) and volume growth, particularly in grain, intermodal, and metals/minerals. These gains were partially offset by a stronger Canadian dollar, which reduced reported revenues by $65 million in Q3 and $220 million for the nine months.
Profitability:
- Net Income: Increased 21% in Q3 and 41% for the nine months. The nine-month increase included a one-time deferred income tax recovery of $250 million due to lower Canadian corporate tax rates.
- Operating Expenses: Declined 1% in Q3 despite higher fuel costs, due to lower casualty expenses, labor savings, and favorable currency translation. For the nine months, expenses rose 1% primarily due to fuel costs and depreciation.
- Operating Ratio: Improved significantly to a record 57.4% in Q3 (down 5.9 points) and 60.6% for the nine months (down 3.8 points).
Operational Metrics: Freight volume (Revenue Ton Miles) increased 6% in Q3 and 4% for the nine months. Fuel costs rose 30% in Q3 due to higher average fuel prices ($2.33/gallon vs. $1.79/gallon in 2005), though productivity improvements mitigated the impact.
Guidance, Outlook, and Risks
Guidance Revision:
- 2006 Full-Year: CN revised its adjusted diluted EPS guidance upward to approximately $3.40 (excluding the $250 million tax recovery).
- 2006 Free Cash Flow: Expected to be approximately $1.3 billion.
- 2007 Outlook: Management expects diluted EPS growth in the "10% plus" range. Free cash flow is projected at approximately $800 million, lower than 2006 due to higher Canadian income tax payments.
Management Commentary: CEO E. Hunter Harrison highlighted "exceptional" results driven by revenue growth, asset utilization, and cost control. The company's "precision railroading" model continues to drive efficiency.
Risks and Contingencies:
- Labor Negotiations: Bargaining has begun with Canadian unions (UTU and CAW) whose agreements expire December 31, 2006. A legal strike or lockout position could be reached as early as January 10, 2007, if no settlement is reached.
- Environmental Liabilities: Accruals for environmental costs were $131 million. Future costs related to remediation and compliance cannot be precisely estimated.
- Legal Claims: Reserves for personal injury and other claims totaled $647 million.
- Market Risks: Exposure to fuel price volatility, currency fluctuations (CAD/USD), and economic slowdowns in North America and Asia.
Investor Verification Checklist
- Tax Impact: Verify the sustainability of the $250 million deferred income tax recovery included in 2006 net income; this is a non-recurring item.
- Adjusted EPS: Confirm the $3.40 adjusted EPS guidance excludes the tax recovery to understand core operational performance.
- Labor Status: Monitor the progress of Canadian labor negotiations (UTU and CAW) expiring end of 2006 for potential strike/lockout risks in early 2007.
- Currency Sensitivity: Assess the impact of the strengthening Canadian dollar, which reduced net income by $15 million in Q3 and $50 million for the nine months.
- Fuel Hedging: Note that the fuel hedging program was terminated; future earnings are more exposed to spot fuel price volatility.
- Capital Expenditures: Verify the $1.55 billion capital program for 2006, with over $1 billion allocated to infrastructure maintenance and safety.