CP

Business Context and Reporting Period

Company: Canadian Pacific Railway Limited (CP)

Filing Type: Form 6-K (Report of Foreign Issuer)

Reporting Period: Second Quarter ended June 30, 2012 (Interim Results)

Date of Filing: July 25, 2012

Business Overview: CP operates a transcontinental railway in Canada and the United States, providing freight transportation, logistics, and supply chain services. The quarter was significantly impacted by a nine-day strike in Canada (May 23 – June 1, 2012) and a major management transition involving the appointment of E. Hunter Harrison as President and CEO.

Key Financial Metrics

Note: All figures are in Canadian dollars unless otherwise specified. YTD figures represent the six months ended June 30.

Material Changes vs. Prior Period

• Revenue Growth: Total revenues increased 8% in Q2 and 13% YTD compared to 2011. Growth was driven by higher volumes in Industrial/Consumer products and Automotive sectors, higher freight rates, and favorable foreign exchange impacts, partially offset by the strike.
• Profitability: While Operating Income increased 3% in Q2 and 51% YTD, Net Income decreased 20% in Q2 (due to significant one-time charges) but increased 51% YTD.
• Operating Ratio: The Q2 operating ratio worsened to 82.5% (up 80 basis points) primarily due to the strike and management transition costs. However, the YTD ratio improved significantly to 81.3% (down 470 basis points) due to operational efficiencies and volume growth.
• Strike Impact: The nine-day strike is estimated to have reduced diluted EPS by $0.25 to $0.30. It caused a loss of revenue but also resulted in cost savings in compensation, fuel, and equipment rents.
• Management Transition: Significant items, including management transition and advisory costs, negatively impacted Q2 diluted EPS by approximately $0.30. This included a $38 million charge for CEO transition costs.
• Tax Rate Change: An Ontario corporate income tax rate change resulted in an $11 million income tax expense in the quarter, increasing the effective tax rate to 31.8% for Q2.

Guidance, Outlook, and Risks

• Management Commentary: New CEO E. Hunter Harrison emphasized a focus on improving service offerings and driving long-term shareholder value, citing CP as a strong franchise with positive market opportunities.
• Capital Expenditures: CP expects 2012 capital programs to range between $1.1 billion and $1.2 billion. This includes $800 million for asset preservation, $275 million for strategic enhancements, and $50 million for regulatory requirements (Positive Train Control).
• Pension Outlook: Defined benefit pension contributions are estimated between $100 million and $125 million annually through 2016. Pension expense for 2012 is expected to be $41 million.
• Key Risks:
  • Labor Relations: Collective agreements with key Canadian unions (TCRC) are subject to interest arbitration following the strike.
  • Regulatory: Implementation of Positive Train Control (PTC) in the U.S. by 2015 is estimated to cost up to $280 million USD.
  • Market Volatility: Exposure to fuel price fluctuations, foreign exchange rates (CAD/USD), and global economic conditions affecting bulk commodity demand (grain, coal, fertilizers).

Investor Verification Checklist

• Strike Resolution: Verify the status of the interest arbitration process with the Teamsters Canada Rail Conference and potential for future labor disruptions.
• Transition Costs: Confirm the full extent of one-time charges related to the CEO transition and the $20 million payment to Pershing Square Capital Management.
• Operational Metrics: Monitor "Car miles per car day" and "Average train speed" to assess the effectiveness of the new management's operational efficiency initiatives.
• Tax Rate Normalization: Review future effective tax rates to determine if the 31.8% Q2 rate is an anomaly or a new baseline due to Ontario legislation.
• Capital Spending: Track actual capital expenditures against the $1.1B–$1.2B guidance, specifically regarding PTC implementation costs.