CP

Business Context and Reporting Period

Company: Canadian Pacific Railway Limited (CP)
Filing Type: Form 6-K (Report of Foreign Issuer)
Reporting Period: Third Quarter and Nine Months Ended September 30, 2008
Release Date: October 28, 2008

CP is a major North American railway. The reporting period covers the third quarter of 2008, a time marked by global economic uncertainty, declining bulk volumes, and significant volatility in fuel prices and foreign exchange rates. The company is in the process of fully consolidating the Dakota, Minnesota & Eastern Railroad (DM&E) acquisition, effective October 30, 2008.

Key Financial Metrics

Note: All figures in Canadian dollars unless otherwise specified.

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 7% in Q3 and 3% for the first nine months. Freight revenues rose 8% in Q3, driven by pricing strength and fuel surcharges, despite volume declines in bulk commodities (grain, forest products).
• Expense Pressure: Operating expenses increased 11% in Q3, primarily due to a 49% ($90 million) surge in fuel costs. Fuel expenses for the nine months rose 39%.
• Profitability Decline: Net income dropped 21% in Q3 and 31% for the nine months. This decline is largely attributed to the absence of a $64 million foreign exchange gain on long-term debt recorded in Q3 2007 and charges related to Asset Backed Commercial Paper (ABCP) investments.
• Adjusted Performance: Excluding foreign exchange impacts on debt and ABCP charges, adjusted diluted EPS decreased only 2% in Q3 ($1.20 vs $1.23) and 7% for the nine months ($2.92 vs $3.13).
• Operating Efficiency: The operating ratio improved 340 basis points sequentially to 76.0% in Q3, reflecting operational recovery and cost containment efforts.

Guidance, Outlook, and Risks

2008 Outlook

• Adjusted Diluted EPS: Confirmed in the range of $4.00 – $4.20.
• Revenue Growth: Revised down to 4–6% (previously 6–8%) due to lower fuel prices impacting fuel surcharges.
• Operating Expenses: Expected to increase 8–10% (previously 11–13%) due to lower fuel costs.
• Free Cash Flow: Expected to be approximately $150 million.
• Assumptions: Outlook assumes an average exchange rate of C$1.04/US$1.00 and crude oil (WTI) averaging US$105/barrel.

Key Risks and Contingencies

• ABCP Investment: CP holds $144 million in Canadian Non-Bank Asset Backed Commercial Paper. The company has taken cumulative charges of approximately 49% of the original value. Continued uncertainty regarding the restructuring process could lead to further material changes in value.
• DM&E Acquisition: Regulatory approval was received for the acquisition of Dakota, Minnesota & Eastern Railroad, effective October 30, 2008. Future contingent payments of up to US$1.05 billion may be payable based on milestones.
• Regulatory: An appeal is pending regarding a Canadian Transportation Agency decision to adjust maximum revenue entitlements for regulated grain movements.
• Market Conditions: Global economic uncertainty and volatility in energy commodity prices remain significant risks.

Investor Verification Checklist

• ABCP Valuation: Verify the latest status of the ABCP restructuring and potential for further write-downs beyond the $72.7 million fair value recorded.
• DM&E Consolidation: Confirm the impact of the full consolidation of DM&E on Q4 2008 results and future debt service obligations.
• Fuel Hedging: Review the effectiveness of fuel recovery programs and derivative hedges in mitigating the impact of volatile diesel prices.
• Foreign Exchange Sensitivity: Assess the impact of the strengthening Canadian dollar on future earnings, particularly regarding US-dollar denominated debt and revenues.
• Grain Revenue: Monitor the outcome of the appeal regarding the Canadian Transportation Agency's grain revenue adjustment decision.