DBRS Morningstar Confirms Ratings on Canadian Pacific Railway Company at BBB (high) and R-2 (high), Under Review with Negative Implications

DBRS Limited (DBRS Morningstar) confirmed the Issuer Rating, Medium-Term Notes rating, and Unsecured Debentures rating on Canadian Pacific Railway Company (CP or the Company) at BBB (high) as well as its Commercial Paper rating at R-2 (high). All the ratings are still Under Review with Negative Implications. The rating confirmations reflect the Company’s solid operating performance and efficiency across its network and a strong recovery from the Coronavirus Disease (COVID-19)-related disruptions. The confirmations also reflect the Company’s commitment to a balanced financial policy that favours funding share repurchases (currently paused) with internally generated cash flows. However, the ratings continue to be Under Review with Negative Implications because of the pending acquisition of Kansas City Southern (KCS), which would potentially lead to higher financial leverage in the near to medium term. DBRS Morningstar believes the KCS acquisition will transform CP, leading to a much stronger business risk profile. Furthermore, CP is committed to bringing back its financial leverage to within the 2.0 times (x) to 2.5x range over the course of two to three years by (1) realizing revenue and cost synergies from the KCS acquisition and (2) repaying debt though internally generated cash flows as it has suspended its share repurchase program. However, this will happen over the course of two to three years, thus the associated increment in leverage following the acquisition will not be fully compensated by the improvements in CP’s business risk profile.

In the year to date ended September 30, 2021, CP’s revenue and revenue-ton-miles rose 4.5% and 1.9%, respectively, year over year (YOY). CP’s merchandise segment, which includes (1) forest products; (2) energy, chemicals, and plastics; (3) metals, minerals, and consumer products; and (4) automotive products, all witnessed YOY volume growth. On the bulk side, coal, sulphur, and fertilizer volumes were higher YOY, while volumes of Canadian grain (almost 12% of CP’s total revenue) and potash declined. The Company continued to enhance operating efficiencies by increasing train lengths and weights, thus leading to better fuel efficiencies. However, the Company faced hurdles in higher fuel costs, a stronger Canadian dollar relative to the U.S. dollar than before, supply chain challenges, and congestion at ports. All of these resulted in higher per unit operating costs. Therefore, while EBITDA was flat YOY, the operating ratio was 1.9% higher. For 2021, CP forecasts low-single-digit volume growth, versus its earlier guidance of high-single-digit growth, mainly because of a 40% YOY decline forecast in Canadian grain volumes in 2021.

CP’s shareholders are scheduled to vote on the KCS acquisition on December 8, 2021, and CP plans to close the voting trust during Q4 2021 or at the latest by Q1 2022. CP will borrow the additional USD 8.5 billion to pay the cash component of the merger consideration to the KCS shareholders. CP forecasts that it will take approximately 12 months for the U.S. Surface Transportation Board (STB) to review the merger. Upon approval by the STB the two entities (i.e., CP and KCS) will fully integrate, which is when the revenue synergies would start kicking in. CP expects almost $1 billion in annual EBITDA synergies, more or less equally spread out among 2023, 2024, and 2025. CP has suspended share repurchases since March 2021 to generate higher levels of cash flow that could be applied to deleveraging.

DBRS Morningstar expects to resolve the Under Review with Negative Implications status once it is clear that the acquisition will close as expected and that regulatory approvals, in particular by the STB, are granted. DBRS Morningstar believes that the Company should be able to maintain an investment-grade rating even in a case in which deleveraging would be slower than currently anticipated. However, a negative rating action could be limited to one notch based on the improved business profile if the Company shows it can deleverage toward its stated target within a two- to three-year time frame.

ESG CONSIDERATIONS
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

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

The principal methodologies are Rating Companies in the Railway Industry (January 26, 2021; https://www.dbrsmorningstar.com/research/372750), DBRS Morningstar Criteria: Commercial Paper Liquidity Support for Nonbank Issuers (March 9, 2021; https://www.dbrsmorningstar.com/research/375001), and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (May 31, 2021; https://www.dbrsmorningstar.com/research/379424) which can be found on dbrsmorningstar.com under Methodologies & Criteria. Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (February 3, 2021; https://www.dbrsmorningstar.com/research/373262).

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at [email protected].

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar did not have access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar trends and ratings are under regular surveillance.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at [email protected].

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