DBRS Morningstar Downgrades Ratings of Canadian Pacific Railway Company to BBB and R-2 (middle), With Stable Trends

DBRS Limited (DBRS Morningstar) downgraded the Issuer Rating, Medium-Term Notes rating, and Unsecured Debentures rating of Canadian Pacific Railway Company (CP or the Company) to BBB from BBB (high) and downgraded its Commercial Paper rating to R-2 (middle) from R-2 (high). In addition, DBRS Morningstar removed all ratings from Under Review With Negative Implications. All the ratings carry Stable trends.

The rating actions followed the announcement that Kansas City Southern’s (KCS) voting shares have been placed into a voting trust and exchanged for a combination of CP shares and cash. DBRS Morningstar therefore downgraded the ratings as the cash component of the total consideration is debt-funded, which leads to higher financial leverage in the near to medium term (Cash flow-to-debt close to 20% and debt-to-EBITDA of more than 4.0 times (x)). DBRS Morningstar believes that the KCS acquisition will transform CP, leading to a stronger business risk profile. Furthermore, CP is committed to bringing its financial leverage back to within the 2.0x to 2.5x range by (1) realizing revenue and cost synergies from the KCS acquisition and (2) repaying debt though internally generated cash flow, 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 is not fully compensated by the improvements in CP’s business risk profile.

The following developments preceded today’s closing of KCS shares into a voting trust: (1) KCS shareholders approved the CP-KCS merger on December 10, 2021; (2) CP shareholders approved the same on December 8, 2021; (3) the regulatory approvals from the Mexican regulatory authorities were obtained in November 2021; (4) CP raised USD 6.7 billion (CAD 8.5 billion) and CAD2.2 billion in debt financing on December 2, 2021, and November 24, 2021, respectively—financing needed for cash consideration required for the acquisition and closing of KCS shares into the voting trust; and (5) the U.S. Surface Transportation Board (STB) reaffirmed the use of a voting trust on September 30, 2021.

CP forecasts that it will take approximately 12 months for the STB to review the merger; the STB accepted the application on November 23, 2021. Upon approval by the STB, the two entities (CP and KCS) will fully integrate and the revenue synergies will kick 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. The Stable trends reflect DBRS Morningstar’s expectation that the Company’s financial metrics should remain commensurate with the current ratings even if deleveraging is slower than anticipated. However, DBRS Morningstar would consider a negative rating action if there is an erosion in leverage caused by weaker earnings and/or higher debt to fund shareholder distributions, such that cash flow-to-debt declines below 20% and debt-to-EBITDA increases above 5.0x on a sustained basis. While it is unlikely in the near-to-medium term, DBRS Morningstar may consider a positive rating action if cash flow-to-debt were to increase above 30% and debt-to-EBITDA were to trend below 2.5x on a sustained basis, a significant improvement from the currently high level of financial leverage (cash flow-to-debt of 20% and debt-to-EBITDA of greater than 4.0x) caused by incremental debt incurred to pay the cash consideration for the KCS shares.

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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