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, 2007
Business Overview: CN operates a rail network 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 (C$ Millions) | Q2 2007 | Q2 2006 | 6M 2007 | 6M 2006 |
|---|---|---|---|---|
| Revenues | 2,027 | 2,000 | 3,933 | 3,897 |
| Operating Income | 811 | 805 | 1,372 | 1,430 |
| Net Income | 516 | 729 | 840 | 1,091 |
| Diluted EPS | $1.01 | $1.35 | $1.63 | $2.01 |
| Adjusted Diluted EPS | $0.95 | $0.89 | $1.57 | $1.55 |
| Operating Ratio | 60.0% | 59.8% | 65.1% | 63.3% |
| Cash from Operations | 739 | 405 | 1,002 | 1,024 |
| Free Cash Flow | 227 | 422 | 51 | 740 |
| Total Debt (Long-term + Current) | 5,559 | 5,604 | 5,559 | 5,604 |
Note: Net Income and EPS figures for 2007 include a deferred income tax recovery of C$30 million ($0.06/share). 2006 figures include a recovery of C$250 million ($0.46/share). Adjusted figures exclude these items.
Material Changes vs. Prior Period
- Revenue Growth: Q2 revenues increased 1% to C$2,027 million, driven by freight rate increases and improved traffic mix. This was offset by a stronger Canadian dollar, lower fuel surcharge revenues, and weakness in forest products.
- Profitability: Reported Net Income decreased 29% year-over-year in Q2 primarily due to the significantly smaller tax recovery in 2007 compared to 2006. However, Adjusted Net Income increased 7% (C$486 million vs. C$479 million).
- Operating Expenses: Increased 2% in Q2 to C$1,216 million, driven by higher equipment rents, fuel costs, and purchased services. This was partially offset by lower casualty expenses and labor costs.
- Operating Ratio: Deteriorated by 0.2 points in Q2 to 60.0% and by 1.8 points for the six-month period to 65.1%.
- Volume Trends: Revenue ton-miles (RTM) declined 1% in Q2 and 2% for the six months. However, yield (revenue per RTM) increased 3% in both periods.
- Commodity Performance:
- Strong: Automotive (+17% revenue), Petroleum & Chemicals (+7%), Grain & Fertilizers (+7%).
- Weak: Forest products (-7%), Intermodal (-3%), Metals & Minerals (+4% revenue but -6% volume).
Guidance, Outlook, and Risks
Guidance and Outlook
CN lowered its full-year 2007 earnings guidance. The company now expects full-year adjusted diluted EPS growth of approximately 5%, down from a previous forecast of 10% or more. This outlook assumes:
- Accelerated economic growth in North America in the second half of 2007.
- Crude oil prices (WTI) settling around US$70 per barrel.
- Canadian/U.S. exchange rate remaining around US$0.95.
Management anticipates stronger intermodal volumes following the October start-up of the new Prince Rupert container terminal.
Management Commentary
CEO E. Hunter Harrison noted that CN performed well despite challenges including a June flood shutting down the Prince Rupert line, weakness in the forest products sector, and two illegal blockades of the Toronto-Montreal main line. The company also completed a 28 million share repurchase program and approved a new 33 million share repurchase program.
Risks and Contingencies
- Operational Disruptions: Floods in British Columbia and a first-quarter strike by the United Transportation Union (UTU) in Canada reduced operating income by an estimated C$50 million and net income by C$35 million in the first half.
- Labor Relations: While the UTU strike was resolved via binding arbitration in July 2007, negotiations are ongoing with other unions (United Steelworkers, IBEW) with agreements expiring in December 2007.
- Environmental Liabilities: The company faces potential liabilities for environmental clean-up at approximately 21 Superfund sites. Aggregate accruals for environmental costs were C$117 million as of June 30, 2007.
- Legal Claims: Aggregate reserves for personal injury and other claims were C$520 million.
- Currency: A stronger Canadian dollar negatively impacted the translation of U.S. dollar-denominated revenues.
Investor Verification Checklist
- Adjusted vs. Reported EPS: Verify the impact of the C$30 million tax recovery in 2007 versus the C$250 million recovery in 2006 to understand true operational performance trends.
- Operating Ratio Deterioration: Investigate the drivers behind the 1.8-point increase in the six-month operating ratio, specifically the impact of equipment rents and fuel costs.
- Forest Products Weakness: Assess the duration and severity of the downturn in the forest products sector, which saw a 7% revenue decline.
- Labor Stability: Monitor the status of upcoming negotiations with the United Steelworkers and IBEW, given the recent history of labor disruptions.
- Free Cash Flow: Note the significant drop in six-month free cash flow to C$51 million from C$740 million in the prior year, driven by changes in accounts receivable securitization and higher capital expenditures.
- Share Repurchases: Confirm the execution of the new 33 million share repurchase program approved in July 2007.