Canadian Pacific Railway Limited — Q3 2018 Form 10-Q
Reporting period: Three and nine months ended September 30, 2018. The filing is by Canadian Pacific Railway Limited, not an entity named Canadian Pacific Kansas City Ltd. Financial figures are in Canadian dollars unless otherwise stated.
Business context and financial performance
CP operates a North American freight railway. Q3 growth was led by higher freight volumes, particularly crude, intermodal and potash. The company reported substantially stronger quarterly earnings, while nine-month GAAP net income was slightly lower year over year, largely reflecting foreign-exchange movements on U.S.-dollar debt.
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Revenue | $1,898 million | $1,595 million | $5,310 million | $4,841 million |
| Operating income | $790 million | $622 million | $1,957 million | $1,837 million |
| Net income | $622 million | $510 million | $1,406 million | $1,421 million |
| Diluted EPS | $4.35 | $3.50 | $9.78 | $9.70 |
| Operating ratio | 58.3% | 61.0% | 63.1% | 62.1% |
| Cash from operations | $673 million | $527 million | $1,781 million | $1,449 million |
| Free cash flow (non-GAAP) | $245 million | $214 million | $740 million | $575 million |
Q3 revenue rose 19% and diluted EPS rose 24%. Management cited 13% growth in revenue ton-miles, operating efficiencies and improved asset utilization; higher fuel costs and stock-based compensation partly offset the gains. Adjusted diluted EPS, a non-GAAP measure, was $4.12 for Q3, up 42%, and $9.97 for the first nine months, up 22%. These measures exclude specified items and may not be comparable with similarly named measures at other companies.
Balance sheet, liquidity and capital
- At September 30, cash was $150 million; total assets were $21.109 billion; shareholders’ equity was $7.128 billion.
- Total long-term debt, including current maturities, was $8.286 billion, versus $8.159 billion at December 31, 2017. The company issued $500 million U.S.-dollar 4.0% notes due 2028 and repaid $275 million U.S.-dollar notes and $375 million Canadian-dollar notes at maturity during Q2.
- CP reported $1.0 billion U.S. available under its undrawn revolving facility, plus up to $544 million available under letter-of-credit facilities. It reported no commercial-paper borrowings and compliance with its debt covenant.
- Property additions were $1.084 billion for the first nine months. Management’s updated capital-spending target was $1.6 billion for 2018. Dividends paid were $255 million; share repurchases were $559 million during the first nine months.
- Adjusted net debt to adjusted EBITDA was 2.5 times, compared with 2.7 times a year earlier; management’s long-term target range was 2.0–2.5 times.
Material changes, outlook and management commentary
- Q3 freight revenue increased 20%; crude, intermodal and potash were prominent growth drivers. Nine-month freight revenue rose 10%. Non-freight revenue declined 8% in both periods.
- Quarterly operating ratio improved by 270 basis points. For the first nine months, the reported ratio worsened by 100 basis points; 2017 included a $51 million management-transition recovery. On an adjusted basis, the nine-month ratio was 63.1% in both years.
- Fuel prices rose materially: average fuel price was $2.69 per U.S. gallon in Q3 versus $2.08 a year earlier. Fuel surcharges partly offset higher costs.
- Higher volumes and accelerated track and roadway work contributed to slower train speed and longer terminal dwell in Q3. Train accidents per million train miles increased to 1.12 from 0.99, while the personal-injury rate improved.
- On October 4, CP updated 2018 guidance to adjusted diluted EPS growth in excess of 20% and an effective tax rate of approximately 24.5%–25%. For 2018–2020, it targeted mid-single-digit volume CAGR, double-digit adjusted diluted EPS CAGR, continued margin improvement and capital expenditures of $1.6 billion annually. Assumptions included CAD/USD of 1.30 and diesel at $3.20 per U.S. gallon.
- Management expected approximately $50 million of land-sale gains in Q4 2018. On October 17, CP announced a proposed share repurchase bid for up to approximately 5.68 million shares, subject to exchange acceptance.
- CP expects lease-accounting changes effective in 2019 to materially increase recognized right-of-use assets and lease liabilities. Adoption was being prepared; the filing did not provide a clear quantified impact.
Risks, contingencies and unusual items
- Lac-Mégantic litigation: CP is defending multiple proceedings relating to the 2013 derailment, including a Quebec action reduced to $315 million, an environmental cleanup claim of $95 million, a certified class action seeking unquantified damages, and other claims. CP denies liability; management said the probability of liability and potential losses could not be determined.
- Environmental obligations: The recorded remediation provision was $80 million, with payments expected through 2028. Additional costs from unknown contamination or changing requirements could not be quantified and could materially affect results in the period recognized.
- Market and operating exposure: Risks include foreign-exchange and fuel-price fluctuations, labour disputes, severe weather, capital-project timing, regulation, demand and pricing, and derailments and dangerous-goods transportation.
- Unusual earnings factors: Nine-month results included a $21 million deferred-tax recovery from Iowa and Missouri tax-rate changes and a $55 million pretax FX loss on U.S.-dollar debt. The 2017 comparison included a $51 million management-transition recovery and a $200 million FX gain on debt. These items make GAAP year-over-year comparisons less indicative of underlying operating trends.
- The filing states that disclosure controls were effective and that no material changes to internal control over financial reporting were identified in Q3. No material changes to previously reported risk factors were disclosed.
Important facts for investors to verify
- Reconcile reported and adjusted earnings, especially the effects of debt-related FX, tax changes and the prior-year management-transition recovery.
- Assess whether strong volume growth can be sustained without further service deterioration, given increased dwell, slower train speeds and a higher train-accident rate.
- Compare fuel-price increases with surcharge recovery timing and resulting margins.
- Review the potential range and timing of Lac-Mégantic and environmental liabilities; the filing does not quantify a reliable maximum for the key litigation exposure.
- Track delivery of 2018 guidance and 2018–2020 targets, including capital spending, land-sale assumptions, and the expected 2019 lease-accounting balance-sheet impact.