DBRS Changes Trend on Canadian Pacific Railway Ratings to Negative

DBRS has today changed the trend on the long-term debt ratings of Canadian Pacific Railway Company (CP or the Company) to Negative from Stable. The ratings have been maintained at BBB. The trend change primarily reflects the Company’s currently aggressive financial profile (which is at the low end of the rating range) and uncertainty regarding CP’s ability to generate improvement in its key credit metrics over the near term to levels more appropriate for its rating due to the various headwinds it faces. As well, with the low interest rate environment and weak pension asset performance, the Company’s underfunded pension deficit in 2011 is likely to grow materially. Currently, there is little room for weaker financial metrics or an increase in leverage. If the Company’s metrics decline below the acceptable range for the BBB rating category, a one-notch downgrade may result.

The Company’s financial performance did not improve as expected when DBRS last confirmed the ratings at BBB in November 2010. The November 22, 2010, DBRS press release indicated that “over the next 12 months, DBRS expects the Company’s financial profile to reflect metrics that are more in line with the current rating.” Year to date, CP’s operations have been negatively affected by unusually severe winter weather in Q1 2011, followed by widespread and prolonged flooding conditions along the entire rail supply chain in Q2 2011 and into part of Q3 2011. Higher costs related to increased fuel consumption, equipment rents, additional crew expenses, et cetera, also drove EBITDA and margins downward.

CP reduced debt levels by funding two maturities totalling approximately $345 million with cash during 2011. This led to a modest improvement in the Company’s financial profile, keeping metrics at the BBB level, but at the low end of the range.

With operations returning to “normalized” conditions, we expect earnings to improve in the next 12 months on the basis of higher freight rates (increase in the low single digits), ongoing efficiency improvement and higher volumes. However, the Company faces the following headwinds: (1) economic conditions both in North America and globally showing signs of slowdown, (2) potentially strong competition to recover its reduced market share in the intermodal segment that was lost to its Canadian competitor due to poor weather conditions and supply chain disruptions and (3) uncertainty over the impact of inclement weather, similar to H1 2011. DBRS also expects that the Company will maintain capex spending at high levels (to enhance future earnings), which will likely result in modest positive free cash flows.

With the low interest rate environment and poor pension asset performance, the Company’s underfunded position is likely to materially grow beyond the $673 million reported for December 31, 2010. Even though DBRS does not include pension deficit as debt, the larger deficit could result in higher mandatory pension contributions in future years, which would reduce free cash flow available for debt repayment. The Company has made voluntary contributions of $500 million in 2009 and $650 million in 2010 to reduce its underfunded pension deficit position. Due to expected modest free cash flows, future voluntary contribution, if any, would likely be funded with additional debt.

In the event that credit metrics do not measurably improve over the near term, a one-notch downgrade of the ratings would be likely. Alternatively, the trend would be changed back to Stable should CP report stronger financial performance (in line with the BBB rating) and handle its growing underfunded pension position without impairing its credit metrics (i.e., through equity issuance or by generating additional cash flows through asset monetization).

Notes:
All figures are in Canadian dollars unless otherwise noted.

The applicable methodology is Rating Companies in the North American Railway Industry, which can be found on our website under Methodologies.