CP

Business Context and Reporting Period

Company: Canadian Pacific Railway Limited (CP)
Filing Type: Form 6-K (Report of Foreign Private Issuer)
Reporting Period: Second Quarter ended June 30, 2015 (Interim)
Release Date: July 21, 2015

CP reported record quarterly net income and its lowest operating ratio in company history for the second quarter of 2015. The company operates as a transcontinental railway in Canada and the United States. Management noted that despite a sluggish North American recovery and global economic softness affecting commodity prices, disciplined cost control and efficiency improvements drove profitability.

Key Financial Metrics

Material Changes vs. Prior Period

• Profitability Surge: Net income increased 12% to $390 million in Q2 2015, driven by a 10% increase in operating income to $646 million.
• Operating Efficiency: The Operating Ratio improved by 420 basis points to a record low of 60.9% in Q2 2015.
• Revenue Stability: Total revenues were relatively flat, declining 2% to $1.65 billion in Q2 2015, though freight revenues grew 4% year-to-date.
• Cost Reductions: Fuel expenses dropped significantly by 32% in Q2 2015 ($185 million vs. $273 million) due to lower diesel prices. Compensation and benefits expenses decreased 10%.
• Share Count: Weighted-average diluted shares outstanding decreased by 6% to 165.0 million due to aggressive share repurchases.

Guidance, Outlook, and Risks

Updated 2015 Full-Year Guidance

• Revenue Growth: Expected to be 2-3%.
• Operating Ratio: Expected to be below 62%.
• Adjusted Diluted EPS: Revised to a range of $10.00 to $10.40.
• Capital Expenditures: Approximately $1.5 billion.
• Key Assumptions: CAD/USD exchange rate of $1.25; effective tax rate of 27.5% (excluding discrete items); pension expense of ~$35 million (vs. $52 million income in 2014).

Management Commentary

CEO E. Hunter Harrison emphasized the company's disciplined approach to controlling costs and improving efficiency to offset economic headwinds. The company highlighted its flexibility and ability to respond to changing economic climates.

Risks and Contingencies

• Regulatory Change: CP will no longer be exempt from regular SEC reporting requirements in 2016 due to a change in board composition (majority U.S. citizens/residents). It will file Form 10-K starting in 2016.
• Legal Proceedings: CP is involved in litigation related to the Lac-Mégantic rail accident. While a settlement fund of ~$430 million was approved for the bankrupt Montreal Maine and Atlantic Railway (MM&A), CP denies liability and has not contributed to the fund. The company faces potential claims from shippers and class actions.
• Environmental Liabilities: Accruals for environmental remediation totaled $94 million as of June 30, 2015.
• Significant Items: Q2 2015 results included a $10 million gain from foreign exchange translation on debt and a $23 million income tax expense due to an Alberta provincial tax rate increase.

Investor Verification Checklist

• Share Repurchase Impact: Verify the extent of share count reduction (5.2 million shares repurchased YTD) and its contribution to EPS growth.
• FX Sensitivity: Confirm the impact of the CAD/USD exchange rate assumption ($1.25) on the full-year guidance, given the company's significant U.S. operations.
• Legal Exposure: Monitor the status of the Lac-Mégantic litigation and any potential liability assessments beyond the MM&A settlement fund.
• Regulatory Transition: Review the implications of transitioning to Form 10-K reporting requirements effective January 1, 2016.
• Pension Volatility: Assess the shift from pension income in 2014 to pension expense in 2015 and its effect on future earnings.