CANADIAN PACIFIC KANSAS CITY LTD annual report, FY2015

Business context and reporting period

This is Canadian Pacific Railway Limited’s Form 10-K for the fiscal year ended December 31, 2015, with unaudited quarterly data, including Q4. The filing registrant is Canadian Pacific Railway Limited—not Canadian Pacific Kansas City Ltd. The company operates an approximately 12,500-mile North American rail network and reports one operating segment: rail transportation. Amounts are Canadian dollars unless stated otherwise.

Financial and operating performance

Freight revenue was $6.552 billion, up 1%; non-freight revenue was $160 million. Freight revenue growth reflected a $549 million favorable foreign-exchange effect and stronger Canadian grain revenue, partly offset by lower fuel-surcharge revenue and weaker crude and metals, minerals and consumer-products volumes. Freight carloads declined 2%, while revenue ton-miles and gross ton-miles each declined 3%.

Operating expenses fell 6% to $4.024 billion, principally from lower fuel costs, operating efficiencies and the D&H South sale gain; foreign exchange, pension expense, wage inflation and higher casualty costs offset some savings. The lower fuel price reduced operating expenses by $403 million and fuel-surcharge revenue by $334 million. Net income was pressured by a $297 million foreign-exchange loss on U.S.-dollar debt and higher interest expense.

Q4 2015 revenue was $1.687 billion versus $1.760 billion in Q4 2014; operating income was $677 million versus $708 million; net income was $319 million versus $451 million; and diluted EPS was $2.08 versus $2.63.

Year-end total assets were $19.637 billion and shareholders’ equity was $4.796 billion. Net interest expense rose to $394 million from $282 million; interest coverage declined to 6.0x from 8.2x, and adjusted net debt to adjusted EBITDA increased to 2.8x from 2.2x. The company had an undrawn U.S. $2 billion revolving credit facility and was in compliance with its financial covenant. Dividends declared were $1.40 per share; the company repurchased 13.5 million shares for $2.748 billion.

Material changes versus prior period

• Operating efficiency improved: train speed rose 19% to 21.4 mph, terminal dwell fell 17% to 7.2 hours, and fuel efficiency improved 4%. Average employees fell 5%.
• Traffic was mixed: Canadian grain and potash increased, while crude revenue fell 19%, metals, minerals and consumer-products revenue fell 10%, and domestic intermodal revenue fell 4%.
• Debt increased substantially following U.S.-dollar note issuance; total long-term obligations were $9.012 billion versus $5.712 billion in 2014. Shareholders’ equity declined to $4.796 billion, partly reflecting share repurchases.
• Capital additions increased to $1.522 billion from $1.449 billion. The company completed the sale of D&H South for $281 million and recorded a $68 million gain. It also recorded a $31 million gain on settlement of a separate building-related legal matter.

Outlook, commentary, risks and contingencies

Management’s 2016 outlook was an operating ratio below 59%, double-digit EPS growth from 2015 adjusted diluted EPS of $10.10, and capital expenditures of approximately $1.1 billion. The company expected a normalized 2016 tax rate of approximately 27.5%. These are forward-looking estimates, not guarantees.

Management emphasized service, cost control, asset utilization, safety and workforce development. CP proposed a business combination with Norfolk Southern in Q4 2015; NS had rejected the proposal. On February 9, 2016, CP said it intended to submit a shareholder resolution asking NS’s board to engage in good-faith discussions.

Material risks include economic and commodity-demand weakness, fuel and foreign-exchange volatility, competition and regulation, labour availability or disruption, severe weather, cyber and security threats, environmental liabilities, and accidents involving dangerous goods. The filing describes new Canadian rail-liability requirements and U.S. tank-car and Positive Train Control rules; the PTC deadline was extended to December 31, 2018. The potential financial effect of some regulatory changes was not yet determinable.

Contingencies include litigation related to the 2013 Lac-Mégantic derailment, which involved a different railway. Quebec claimed $409 million for cleanup-related damages; related class, private-party and bankruptcy proceedings were also pending. CP denied liability and stated that potential liability and loss could not be determined at this early stage. A separate CN claim alleging misuse of confidential customer data also had an unestimable potential loss. Environmental remediation accruals were $93 million at year-end; management noted estimates could change as sites, regulations or remediation requirements evolve.

Reported 2015 results included significant items, notably the $68 million D&H South gain, a $47 million early debt-redemption charge, a $23 million tax-rate-change expense and the $297 million non-cash foreign-exchange loss on U.S.-dollar debt. Adjusted figures are non-GAAP and should be considered alongside reported results. Deloitte issued unqualified opinions on the financial statements and internal controls.

Important facts for investors to verify

• Whether adjusted EPS, free cash and adjusted leverage calculations reconcile to GAAP results and are comparable with other companies’ measures.
• How much of revenue and operating improvement reflected foreign exchange, lower fuel prices, asset-sale gains and recurring operating efficiencies.
• Whether weaker crude and other commodity volumes persist, and whether grain, potash and intermodal trends support the 2016 outlook.
• Debt servicing, refinancing and interest-rate exposure after the 2015 borrowing increase, including the effect of currency movements on U.S.-dollar debt.
• Developments in Lac-Mégantic and CN litigation, regulatory compliance costs, environmental remediation and other contingent liabilities.
• Progress against 2016 guidance and capital plans, as well as the status and potential implications of the proposed NS transaction.