Business Context and Reporting Period
Company: Canadian Pacific Railway Limited (CP)
Filing Type: Form 6-K (Interim Report)
Reporting Period: Third Quarter and Nine Months ended September 30, 2008
Business Overview: CP operates a transcontinental railway in Canada and the United States, transporting bulk commodities (grain, coal, sulphur, fertilizers), merchandise freight (automotive, forest products, industrial/consumer goods), and intermodal traffic. The company is in the process of fully consolidating its acquisition of Dakota, Minnesota & Eastern Railroad Corporation (DM&E), effective October 30, 2008.
Key Financial Metrics
| Metric (CAD Millions) | Q3 2008 | Q3 2007 | 9M 2008 | 9M 2007 |
|---|---|---|---|---|
| Total Revenues | $1,264.7 | $1,187.9 | $3,631.9 | $3,519.3 |
| Operating Expenses | $961.5 | $866.2 | $2,879.4 | $2,660.6 |
| Operating Income | $303.2 | $321.7 | $752.5 | $858.7 |
| Net Income | $172.7 | $218.6 | $418.4 | $603.9 |
| Diluted EPS | $1.11 | $1.41 | $2.70 | $3.87 |
| Adjusted Diluted EPS (Excl. FX on LTD & Specified Items) |
$1.20 | $1.23 | $2.92 | $3.13 |
| Operating Ratio | 76.0% | 72.9% | 79.3% | 75.6% |
| Cash Provided by Operating Activities | $282.8 | $341.4 | $625.8 | $933.6 |
| Free Cash (Non-GAAP) |
($0.9) | $96.5 | ($170.2) | $259.1 |
| Long-Term Debt | $4,140.4 | $4,146.2 | $4,140.4 | $2,896.4 |
| Cash and Cash Equivalents | $97.9 | $339.2 | $97.9 | $124.3 |
Material Changes vs. Prior Period
- Revenue Growth: Total revenues increased 6.5% in Q3 and 3.2% year-to-date (YTD) compared to 2007. Freight revenues rose 8.0% in Q3, driven by pricing strength and fuel recoveries, offsetting volume declines in grain and forest products.
- Expense Pressure: Operating expenses increased 11.0% in Q3 and 8.2% YTD. Fuel expenses were the primary driver, rising 48.6% in Q3 due to higher West Texas Intermediate (WTI) prices.
- Profitability Decline: Net income decreased 21.0% in Q3 and 30.7% YTD. This was primarily due to the absence of a large foreign exchange (FX) gain on long-term debt recorded in 2007, lower operating income, and charges related to Asset-Backed Commercial Paper (ABCP).
- Adjusted Performance: Excluding FX gains/losses on long-term debt and specified items, Adjusted Diluted EPS decreased only 2.4% in Q3 and 6.7% YTD, indicating underlying operational stability despite market headwinds.
- Volume Trends: Total carloads decreased 2.4% in Q3 and 0.7% YTD. Grain volumes fell due to a late harvest, and forest products declined due to the US housing market slowdown. Conversely, industrial/consumer products and coal volumes increased.
Guidance, Outlook, and Risks
2008 Outlook Update (October 2008)
Management confirmed the following full-year 2008 guidance, revised to reflect lower fuel prices and economic uncertainty:
- Adjusted Diluted EPS: $4.00 – $4.20 (Confirmed).
- Total Revenue Growth: 4% – 6% (Revised down from 6% – 8%).
- Total Operating Expenses: Increase of 8% – 10% (Revised down from 11% – 13%).
- Free Cash: Approximately $150 million.
- Capital Expenditures: $885 – $895 million.
- Key Assumptions: Average crude oil price of US$105/barrel; Average FX rate of C$1.04/US$1.00; Normalized tax rate of 26% – 27%.
Management Commentary
CEO Fred Green noted that pricing gains and cost containment offset declines in bulk volumes. The operating ratio improved 340 basis points sequentially to 76.0% in Q3. CFO Kathryn McQuade highlighted that while lower fuel prices and a weaker Canadian dollar provided financial benefits, global economic uncertainty remains a significant factor.
Risks and Contingencies
- ABCP Investment: CP holds approximately $144 million in original cost of Canadian third-party ABCP. The estimated fair value was written down to $72.7 million as of September 30, 2008. A charge of $28.1 million was recorded in Q3 2008. Continued uncertainty regarding the restructuring process could lead to further material changes in value.
- Regulatory: The Canadian Transportation Agency directed a downward adjustment of the maximum revenue entitlement for regulated grain. CP has appealed this decision; a retroactive component of approximately $23 million is not considered legally supportable and has not been provided for.
- DM&E Acquisition: Regulatory approval was received on September 30, 2008, with consolidation effective October 30, 2008. Future contingent payments of up to US$1.05 billion may be payable based on milestones.
- Pension Funding: Volatility in pension funding requirements is expected due to market conditions. Estimated contributions for 2009 range from $105 million to $165 million depending on Q4 2008 investment returns.
Investor Verification Checklist
- ABCP Valuation: Verify the assumptions used in the probability-weighted discounted cash flow model for the ABCP investment and monitor the restructuring process for potential further write-downs.
- Fuel Price Sensitivity: Assess the impact of the revised fuel price assumptions (US$105/barrel) on the full-year expense outlook and the effectiveness of fuel recovery programs.
- FX Exposure: Monitor the impact of the Canadian dollar exchange rate on US dollar-denominated debt and revenues, noting the shift from a gain in 2007 to a loss in 2008.
- DM&E Consolidation: Review the impact of the full consolidation of DM&E on Q4 2008 results and the integration of its capital spending.
- Grain Revenue Cap: Track the outcome of the appeal regarding the Canadian Transportation Agency's grain revenue cap decision, specifically the potential $23 million retroactive adjustment.