CNI

Business Context and Reporting Period

Company: Canadian National Railway Company (CN)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: Third quarter ended September 30, 2009 (Q3 2009) and the nine months ended September 30, 2009 (YTD 2009).
Business Overview: CN operates a Class I railroad network spanning Canada and the mid-United States, connecting the Atlantic, Pacific, and Gulf of Mexico coasts. The company manages its operations as a single business segment, focusing on "precision railroading" to improve efficiency and asset utilization.

Key Financial Metrics

Note: All figures are in Canadian dollars unless otherwise specified. Debt figures represent long-term debt excluding current portion.

Material Changes vs. Prior Period

• Revenue Decline: Q3 revenues decreased 18% year-over-year, and YTD revenues decreased 13%. This was primarily driven by significantly lower freight volumes across almost all commodity groups due to the North American and global economic recession.
  • Volume Metrics: Carloads declined 15% in Q3 and 18% YTD. Revenue ton-miles (RTM) declined 11% in Q3 and 13% YTD.
  • Commodity Impact: Metals and minerals (-32%), automotive (-25%), and forest products (-24%) saw the steepest revenue declines in Q3.
• Expense Reduction: Operating expenses declined 18% in Q3 and 11% YTD. This was largely due to lower fuel costs (fuel expense dropped 51% in Q3), reduced purchased services, and cost-containment measures.
  • Fuel Prices: Average fuel price per gallon dropped from $3.84 in Q3 2008 to $2.19 in Q3 2009.
• Profitability: Net income decreased 16% in Q3 and 4% YTD. The operating ratio remained essentially flat in Q3 (62.7% vs 62.6%) but increased slightly YTD (68.0% vs 67.0%).
• Foreign Exchange: The weaker Canadian dollar provided a positive translation impact, increasing Q3 net income by approximately C$15 million.

Guidance, Outlook, and Unusual Items

Management Commentary and Outlook

CEO E. Hunter Harrison noted that while Q3 was challenging with significant market weakness, the decline in RTM (11%) was a sequential improvement over Q2 (14%). Management believes several markets may have hit bottom. Productivity gains, including an 11% increase in system train speeds and a 9% reduction in average dwell time, position the company for eventual traffic recovery. CN plans to invest approximately C$1.5 billion in capital programs for 2009, with C$1 billion targeted at track infrastructure.

Unusual Items and Adjustments

• Deferred Income Tax Recoveries: Q3 2009 included a C$15 million recovery; YTD 2009 included C$58 million. These resulted from tax matter resolutions, lower provincial tax rates, and foreign investment recapitalization.
  • Adjusted Net Income: Excluding these items, adjusted Q3 net income was C$446 million ($0.94/share), a 12% decline from the prior year.
• Asset Disposal: In Q1 2009, CN sold the Weston subdivision in Toronto, recognizing a gain of C$157 million (C$135 million after-tax). This is excluded from adjusted performance measures.
• Acquisition Costs: CN incurred C$49 million in acquisition-related costs for the Elgin, Joliet and Eastern Railway Company (EJ&E) in Q1 2009, which were expensed.

Risks and Contingencies

• Regulatory Oversight: The EJ&E acquisition is subject to a five-year monitoring period by the U.S. Surface Transportation Board (STB), including conditions for infrastructure improvements and community mitigation. Challenges to the Environmental Impact Statement remain pending.
• Legal and Environmental: Aggregate reserves for personal injury and other claims were C$381 million. Environmental accruals totaled C$109 million. Management considers provisions adequate but notes outcomes cannot be predicted with certainty.
• Labor: Negotiations are ongoing for Canadian collective agreements (expiring Dec 2008) and various U.S. agreements. The right to strike or lockout exists for certain Canadian units as of October 9, 2009.

Investor Verification Checklist

• Volume Recovery: Verify if the sequential improvement in RTM decline (from 14% in Q2 to 11% in Q3) continues into Q4, indicating a stabilization of freight demand.
• Operating Ratio Stability: Monitor the operating ratio to ensure cost containment measures continue to offset revenue declines as fuel prices fluctuate.
• Acquisition Integration: Assess the operational impact and cost realization of the EJ&E acquisition, including compliance with STB mitigation conditions.
• Labor Negotiations: Track the status of Canadian and U.S. labor negotiations to evaluate the risk of work stoppages.
• Adjusted Earnings: Review non-GAAP adjusted earnings to understand core operational performance excluding one-time tax recoveries and asset sale gains.