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, 2012
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 manages its operations as a single business segment, focusing on precision railroading to improve velocity, reliability, and asset utilization.
Key Financial Metrics
| Metric (CAD Millions) | Q2 2012 | Q2 2011 | 6M 2012 | 6M 2011 |
|---|---|---|---|---|
| Revenues | $2,543 | $2,260 | $4,889 | $4,344 |
| Operating Income | $985 | $874 | $1,778 | $1,519 |
| Net Income | $631 | $538 | $1,406 | $1,206 |
| Diluted EPS | $1.44 | $1.18 | $3.18 | $2.63 |
| Operating Ratio | 61.3% | 61.3% | 63.6% | 65.0% |
| Free Cash Flow (6M) | $703 (vs. $823 in 6M 2011) | |||
| Total Debt (Long-term + Current) | $6,775 (as of June 30, 2012) | |||
| Cash and Cash Equivalents | $345 (as of June 30, 2012) |
Adjusted Metrics (Non-GAAP): Adjusted Q2 2012 Net Income was $659 million ($1.50 diluted EPS), excluding a net income tax expense of $28 million. Adjusted 6M 2012 Net Income was $1,182 million ($2.67 diluted EPS), excluding the tax expense and a $281 million gain on the disposal of the Bala-Oakville rail lines.
Material Changes vs. Prior Period
- Revenue Growth: Revenues increased 13% in Q2 and 13% for the first half of 2012. This was driven by higher freight volumes (Revenue Ton-Miles up 8% in Q2), freight rate increases, higher fuel surcharges, and a positive translation impact from the weaker Canadian dollar.
- Commodity Performance: Double-digit revenue growth was recorded in metals and minerals (20%), petroleum and chemicals (19%), automotive (18%), intermodal (16%), and coal (15%). Grain and fertilizers revenues declined 1% due to lower volumes.
- Operating Expenses: Expenses rose 12% in Q2 to $1,558 million, primarily due to higher labor and fringe benefits, increased fuel costs, and the negative translation impact of the weaker Canadian dollar on U.S.-denominated expenses.
- One-Time Items: The first half of 2012 included a $281 million pre-tax gain from the sale of the Bala-Oakville rail lines. The first half of 2011 included a $288 million pre-tax gain from the sale of the Lakeshore East rail lines.
- Foreign Currency: On a constant currency basis, Q2 and 6M 2012 net income would have been lower by $13 million and $17 million, respectively, due to exchange rate fluctuations.
Guidance, Outlook, and Risks
Revised 2012 Financial Outlook
CN has revised its 2012 outlook upward based on strong first-half performance and positive economic assumptions:
- Adjusted Diluted EPS: Targeting up to 15% growth over 2011 (previously 10%), despite an additional pension expense of approximately $100 million.
- Free Cash Flow: Targeting approximately $1 billion (previously ~$950 million), accounting for a potential additional $250 million voluntary pension contribution in Q4.
- Capital Spending: Plans to invest approximately $1.8 billion in 2012, with over $1 billion targeted for track infrastructure.
Key Assumptions
- North American industrial production increase of ~3.5%.
- U.S. housing starts of ~750,000 units and motor vehicle sales of ~14.5 million units.
- Canadian-U.S. exchange rate slightly below parity for 2012.
- Crude oil (WTI) price range of US$85-US$95 per barrel.
Risks and Contingencies
- Legal Proceedings: CN is pursuing legal action against its former CEO regarding the forfeiture of approximately $18 million in RSU payouts and $1.5 million in annual retirement benefits due to alleged breaches of non-compete and non-disclosure agreements. No gain has been recorded pending resolution.
- Pension Funding: A solvency deficit of approximately $1.3 billion was identified in Canadian pension plans. CN made voluntary contributions of $450 million in Q1 2012 and is reviewing a potential additional $250 million contribution in 2012.
- Regulatory & Environmental: Ongoing compliance with environmental laws (approx. $120 million accrual for environmental costs) and regulatory requirements such as Positive Train Control (PTC) implementation by 2015 (estimated cost $185 million).
- Labor: Collective agreements with Canadian unions were ratified in early 2012; U.S. workforce agreements are under renegotiation with moratoriums in place.
Investor Verification Checklist
- Adjusted vs. GAAP: Verify the impact of the $281 million Bala-Oakville disposal gain on 6M 2012 net income and the $28 million tax expense on Q2 results.
- Pension Contributions: Confirm the timing and amount of the potential additional $250 million voluntary pension contribution in Q4 2012 and its impact on free cash flow.
- Constant Currency: Assess operational performance excluding the favorable foreign exchange translation impact on revenues and the unfavorable impact on expenses.
- Legal Contingency: Monitor the status of the litigation against the former CEO regarding the forfeiture of benefits.
- Capital Expenditures: Track the execution of the $1.8 billion capital program, specifically the $1 billion allocated to track infrastructure.