CP

Business Context and Reporting Period

Company: Canadian Pacific Railway Limited (CP)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: Third Quarter and First Nine Months ended September 30, 2009
Business Overview: CP operates a transcontinental railway in Canada and the United States, transporting bulk commodities (grain, coal, sulphur, fertilizers), merchandise freight, and intermodal traffic. The company fully consolidated the results of Dakota, Minnesota & Eastern Railroad (DM&E) for the 2009 periods, whereas 2008 results were reported on an equity income basis until October 2008. Comparisons in this filing utilize a "pro forma" basis to redistribute DM&E results for 2008 to ensure comparability.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Decline: On a pro forma basis, total revenues decreased 20.3% in Q3 and 18.3% for the first nine months of 2009 compared to 2008. This was primarily driven by lower traffic volumes due to the global recession and reduced fuel surcharge revenues.
• Cost Reductions: Operating expenses decreased 20.1% in Q3 and 16.9% for the nine months on a pro forma basis. Savings were achieved through lower fuel prices, reduced volumes (fewer train starts), and cost reduction initiatives, partially offset by unfavorable foreign exchange impacts.
• Net Income Volatility: While GAAP Net Income increased 14.5% in Q3 2009, this was largely due to non-recurring gains. Adjusted Net Income (excluding FX and specified items) decreased 21.8% in Q3 and 33.8% for the nine months, reflecting the underlying impact of the recession on operating income.
• Foreign Exchange: The Canadian dollar weakened against the US dollar (average rate $1.11 in Q3 2009 vs $1.04 in Q3 2008), providing a favorable impact on US-dollar denominated revenues but an unfavorable impact on expenses.

Guidance, Outlook, and Unusual Items

Unusual Items and Non-GAAP Adjustments

• Asset Sales: Significant gains were recorded from the sale of Windsor Station and land in Western Canada ($79.1 million pre-tax) in Q3 2009, and the sale of a portion of the Detroit River Tunnel Partnership ($81.2 million pre-tax) in Q2 2009.
• FX on Long-Term Debt: CP recorded a foreign exchange loss on long-term debt of $0.1 million in Q3 2009, compared to a loss of $2.9 million in Q3 2008. For the nine months, there was a gain of $2.7 million in 2009 versus a loss of $12.4 million in 2008.
• ABCP Restructuring: Gains of $1.6 million (Q3) and $6.3 million (9M) were recorded on the change in fair value of long-term floating rate notes received in replacement of Asset-Backed Commercial Paper (ABCP), contrasting with significant impairments in 2008.

Management Commentary and Outlook

• Capital Program: CP revised its 2009 capital expenditure guidance to a range of $800 million to $820 million. This increase from previous guidance is due to the buyout of operating leases, expected to be offset by equipment sales in the latter half of 2009.
• Operational Efficiency: Management emphasized strong cost control and resource management despite volume pressures. Fuel efficiency improved, and train miles were reduced by consolidating trains.
• Financial Covenants: The interest coverage ratio decreased to 3.2x (below the 4.0x target) due to lower earnings and FX impacts, but management expects improvement as volumes recover. The total debt to total capitalization ratio improved to 38.1% (target <50%).
• Risks: Key risks include the global economic recovery timeline, regulatory rate proceedings (specifically regarding Teck Coal Limited), pension funding volatility, and labor negotiations.

Investor Verification Checklist

• Adjusted Earnings Trend: Verify the sustainability of earnings by focusing on "Adjusted Diluted EPS" ($0.85 for Q3) rather than GAAP EPS, which is inflated by one-time asset sales.
• Volume Recovery: Monitor traffic volumes (Revenue Ton-Miles and Carloads) for signs of recovery from the global recession, as these are the primary drivers of future revenue.
• Foreign Exchange Sensitivity: Assess the impact of the Canadian/US dollar exchange rate on future earnings, as a significant portion of revenue and debt is US-denominated.
• Pension Funding: Review the pension plan deficit and funding requirements, which are sensitive to discount rates and equity market performance, potentially impacting future cash flows.
• Regulatory Rate Outcomes: Track the impact of the Final Offer Arbitration with Teck Coal Limited on coal revenue rates, which have an adverse impact on the business.