Business Context and Reporting Period
Company: Canadian Pacific Railway Limited (CP)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: Six months ended June 30, 2009 (Unaudited)
Filing Date: September 30, 2009
Context: This filing provides a reconciliation of Canadian GAAP to U.S. GAAP for interim financial results. It details accounting differences, fair value measurements, derivative activities, and significant contingencies related to the acquisition of Dakota, Minnesota and Eastern Railroad Corporation (DM&E).
Key Financial Metrics (U.S. GAAP)
All figures in millions of Canadian dollars (CAD) unless otherwise noted.
| Metric | Six Months Ended June 30, 2009 | Six Months Ended June 30, 2008 |
|---|---|---|
| Net Income | $192.8 | $224.9 |
| Comprehensive Income | $200.8 | $238.5 |
| Revenues Less Operating Expenses | $321.0 | $439.6 |
| Basic Earnings Per Share | $1.17 | $1.46 |
| Diluted Earnings Per Share | $1.17 | $1.45 |
| Income Taxes Paid | $9.7 | $58.1 |
Balance Sheet Adjustments (U.S. GAAP vs. Canadian GAAP):
Total assets are lower by $854.7 million under U.S. GAAP, primarily due to the recognition of unfunded pension liabilities ($1,201.6 million reduction in assets) and differences in joint venture accounting. Total liabilities are higher by $665.9 million, driven largely by the underfunded status of defined benefit plans ($984.5 million increase).
Material Changes and Accounting Differences
- Net Income Decline: U.S. GAAP net income decreased by approximately 14% year-over-year ($192.8M vs. $224.9M). A significant portion of the variance between Canadian and U.S. GAAP net income is attributed to pension costs (reduction of $13.7M) and stock-based compensation (reduction of $15.9M) under U.S. GAAP.
- Joint Venture Accounting: Effective April 1, 2009, CP discontinued proportionate consolidation of the Detroit River Tunnel Partnership (DRTP) following a sale of part of its interest (reducing ownership from 50% to 16.5%). The remaining interest is now accounted for using the equity method. Equity income from DRTP was $2.2 million for the six months ended June 30, 2009.
- Pension and Post-Retirement Benefits: Under U.S. GAAP, the company must recognize the over/under-funded status of defined benefit plans on the balance sheet. This resulted in a significant liability adjustment not present under Canadian GAAP.
- Stock-Based Compensation: U.S. GAAP requires fair value measurement for all share-based awards, whereas Canadian GAAP used the intrinsic method for liability awards. This resulted in a $15.9 million expense increase under U.S. GAAP.
Outlook, Risks, and Contingencies
Guidance and Management Commentary
- Pension Contributions: The company expects total contributions to defined benefit pension plans in 2009 to be between $100 million and $150 million. As of June 30, 2009, $43.7 million had been disbursed.
- Dividends: Dividends declared per share for the six months ended June 30, 2009, were $0.4950, unchanged from the prior year period.
Risks and Contingencies
- DM&E Contingent Payments: As part of the DM&E acquisition, future contingent payments of up to approximately US$1.05 billion (plus interest and inflation adjustments) may be payable through December 31, 2025. This includes US$350 million if the Powder River Basin expansion starts before the deadline and up to US$700 million based on volume milestones.
- Derivative and Market Risks:
- Foreign Exchange: The company manages U.S. dollar exposure through natural offsets and hedging. Unrealized FX gains/losses on long-term debt are significant but mitigated by net investment hedges.
- Fuel Price: Residual exposure to fuel price volatility remains despite recovery programs. The company uses swaps and options to manage this risk.
- Interest Rate: The company uses swaps and forward rate agreements to manage the mix of fixed and floating rate debt.
- Credit Risk: Derivative counterparties are limited to investment-grade institutions. Credit risk is mitigated through exposure limits and collateral requirements.
Unusual Items and Fair Value
- Level 3 Fair Value Assets: Long-term floating rate notes valued at $65.2 million (Level 3) as of June 30, 2009. A realized gain of $4.4 million was recognized on the settlement of notes during the period.
- Derivative Gains/Losses: Total derivative gains/losses recognized in income for the six months ended June 30, 2009, were a net loss of $16.3 million, compared to a net gain of $20.3 million in the prior year. This was largely driven by a $16.8 million loss on currency forwards not designated as hedging instruments.
Investor Verification Checklist
- Verify Pension Liability Impact: Confirm the magnitude of the unfunded pension liability ($1,201.6 million asset reduction) and its effect on leverage ratios under U.S. GAAP.
- Review DM&E Milestones: Assess the likelihood of triggering the US$1.05 billion contingent payment obligations based on the Powder River Basin project status and volume targets.
- Analyze Derivative Exposure: Review the $16.8 million loss on non-hedging currency forwards and the company's strategy for managing residual FX and fuel price risks.
- Check Cash Flow Consistency: Reconcile the low income taxes paid ($9.7M) against net income to understand the timing of tax payments and deferred tax impacts.
- Monitor Joint Venture Transition: Verify the financial impact of the shift from proportionate consolidation to the equity method for the DRTP investment.