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 and nine months ended September 30, 2007
Release Date: October 22, 2007

CN is a major North American railroad spanning Canada and the mid-United States. The reporting period was characterized by a strong Canadian dollar, weak forest products markets, and operational challenges including a first-quarter strike and adverse weather.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue: Q3 revenues were essentially flat year-over-year. Growth in Canadian coal, grain, fertilizers, petroleum, chemicals, and automotive segments offset a 13% decline in forest products revenue and the negative translation impact of a stronger Canadian dollar.
• Profitability: Operating income declined 9% in Q3 due to a 6% increase in operating expenses (driven by labor, fuel, and equipment rents). The operating ratio worsened by 3.5 points to 62.0%.
• Net Income: Q3 net income decreased 2% to C$485 million. This decline was mitigated by a C$14 million benefit from favorable tax adjustments. Without this benefit, net income would have declined more significantly.
• Cash Flow: Free cash flow dropped significantly to C$142 million in Q3 (from C$391 million in Q3 2006) and C$193 million for the nine-month period (from C$1,131 million), largely due to changes in working capital and the accounts receivable securitization program.
• Debt: Long-term debt remained relatively stable at C$5.34 billion. The company issued C$550 million in new notes in September 2007 to repay commercial paper and reduce receivables securitization.

Guidance, Outlook, and Risks

• Outlook: Management anticipates continued weak market conditions in forest products and construction materials. The strong Canadian dollar remains a headwind for U.S. dollar-denominated revenues.
• Full-Year Guidance: CN expects full-year 2007 diluted EPS growth of approximately 5%, driven by anticipated gains from the closing of the Central Station Complex and English Welsh and Scottish Railway (EWS) transactions in Q4. Excluding these transaction gains, adjusted diluted EPS is expected to be flat versus 2006.
• Acquisitions & Transactions:
  • EJ&E: Agreed to acquire Elgin, Joliet and Eastern Railway for approx. US$300 million; closing expected mid-2008 pending regulatory approval.
  • Central Station Complex: Agreed to sell Montreal assets for C$355 million, with a leaseback arrangement; expected to close by year-end.
  • EWS: Deutsche Bahn agreed to acquire CN's 32% stake; expected to generate approx. C$85 million in after-tax proceeds.
• Risks: Key risks include currency fluctuations, fuel price volatility, labor disruptions (a Q1 strike cost approx. C$35 million in net income), environmental liabilities (C$109 million accrued), and legal claims (C$500 million accrued).

Investor Verification Checklist

• Transaction Timing: Verify the closing dates and final proceeds for the Central Station Complex sale and the EWS divestiture, as these are critical to meeting full-year EPS guidance.
• Forest Products Recovery: Monitor the 13% revenue decline in the forest products segment to assess if market conditions are stabilizing or if mill closures are permanent.
• Currency Impact: Evaluate the sensitivity of future earnings to the Canadian/US dollar exchange rate, which significantly impacted Q3 results.
• Operating Ratio Trend: Track the operating ratio (currently 62.0%) to ensure cost controls (labor, fuel) are effective against revenue pressures.
• Share Repurchases: Note the aggressive share buyback program (C$452 million in Q3 alone) and its impact on diluted share count and EPS.