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 First Half ended June 30, 2008
Business Overview: CN operates a Class I railroad network spanning Canada and mid-America, 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 velocity, reliability, and asset utilization.
Key Financial Metrics
| Metric | Q2 2008 | Q2 2007 | YTD 2008 | YTD 2007 |
|---|---|---|---|---|
| Revenues (C$ millions) | 2,098 | 2,027 | 4,025 | 3,933 |
| Operating Income (C$ millions) | 707 | 811 | 1,230 | 1,372 |
| Net Income (C$ millions) | 459 | 516 | 770 | 840 |
| Diluted EPS (C$) | 0.95 | 1.01 | 1.59 | 1.63 |
| Operating Ratio (%) | 66.3% | 60.0% | 69.4% | 65.1% |
| Free Cash Flow (C$ millions) | 164 | 227 | 225 | 51 |
Liquidity and Debt:
- Cash and Cash Equivalents: C$161 million as of June 30, 2008 (down from C$310 million at Dec 31, 2007).
- Long-term Debt: C$6,389 million (excluding current portion of C$85 million).
- Debt-to-Total Capitalization: 39.0% (Adjusted ratio: 42.2%).
- Adjusted Debt-to-Adjusted EBITDA: 2.1 times.
Material Changes vs. Prior Period
Revenue Performance:
- Q2 revenues increased 4% (YTD +2%) driven by freight rate increases (approx. two-thirds due to fuel surcharges) and volume growth in Intermodal (+14%), Coal (+8%), and Metals/Minerals (+6%).
- Revenue gains were offset by a stronger Canadian dollar (negative translation impact of C$90 million in Q2) and weakness in Forest Products (-14%) and Automotive (-13%) sectors.
Expense and Profitability:
- Operating expenses rose 14% in Q2 (YTD +9%) primarily due to fuel costs, which surged 60% year-over-year to nearly C$400 million in Q2.
- Operating income declined 13% in Q2 (YTD -10%) as cost increases outpaced revenue growth, widening the operating ratio by 6.3 points in Q2.
- Net income decreased 11% in Q2 (YTD -8%).
Unusual Items:
- Deferred Tax Recoveries: Q2 2008 included a C$23 million recovery (C$0.05/share) due to lower provincial corporate tax rates. YTD 2008 included an additional C$11 million recovery from subsidiary reorganization.
- Foreign Exchange: The stronger Canadian dollar reduced Q2 net income by approximately C$25 million and YTD net income by C$55 million.
- Strike Impact: Q1 2007 results were negatively impacted by a conductors' strike (estimated C$35 million net income impact), making YTD 2008 comparisons partially favorable regarding volume.
Guidance, Outlook, and Risks
Management Commentary:
- CEO E. Hunter Harrison noted strong operational performance despite spiraling fuel costs and economic headwinds.
- Double-digit growth in Intermodal revenues was driven by new container traffic at the Port of Prince Rupert and import strength at Vancouver.
Outlook:
- CN maintains a target for full-year 2008 diluted EPS growth in the mid-single-digit range over 2007 adjusted diluted EPS of C$3.40.
- Key Assumptions: Canadian-U.S. dollar parity; Crude oil (WTI) at ~US$135/barrel; North American economic growth of ~1%.
Risks and Contingencies:
- Acquisition: Pending approval by the Surface Transportation Board (STB) for the acquisition of Elgin, Joliet and Eastern Railway (EJ&E) for approx. US$300 million. An Environmental Impact Statement is required.
- Regulatory: Ongoing review of fuel surcharge methodologies by the STB and potential changes to grain revenue caps in Canada.
- Operational: Exposure to fuel price volatility, severe weather disruptions, and labor negotiations (several collective agreements expiring in late 2008).
- Environmental: Potential liabilities for cleanup costs at approx. 23 Superfund sites; aggregate accruals of C$108 million.
Investor Verification Checklist
- Fuel Surcharge Effectiveness: Verify if the fuel surcharge mechanism continues to fully offset the 60% year-over-year increase in fuel costs.
- Currency Sensitivity: Monitor the CAD/USD exchange rate, as a one-cent change impacts annual net income by approx. C$10 million.
- Commodity Mix: Assess the sustainability of volume declines in Forest Products and Automotive sectors given the U.S. housing and auto market conditions.
- Acquisition Timeline: Track the STB's Environmental Impact Statement process for the EJ&E acquisition to determine closing feasibility in late 2008.
- Capital Expenditures: Confirm adherence to the C$1.5 billion capital program plan, specifically the allocation to track infrastructure and strategic initiatives.