DBRS Morningstar Confirms Canadian Pacific Railway Company at BBB and R-2 (middle), Stable Trends

DBRS Limited (DBRS Morningstar) confirmed the Issuer Rating, Medium-Term Notes rating, and Unsecured Debentures rating of Canadian Pacific Railway Company (CP or the Company) at BBB and the Commercial Paper rating at R-2 (middle). All trends remain Stable.

The ratings are supported by a well-positioned railroad network, high network efficiency, solid operational execution, and experienced management. However, the following factors weigh on the ratings: CP’s high leverage compared with historical levels, the potential economic slowdown, the risk related to the Surface Transportation Board’s (STB) potential approval for the Kansas City Southern (KCS) acquisition, and the subsequent integration risk with KCS. The ratings also reflect management’s continuing commitment toward deleveraging net debt-to-EBITDA to the 2.0 times (x) to 2.5x range from the current 4.1x for the last 12 months ended September 2022 (pro forma for the KCS acquisition; note that DBRS Morningstar focuses on gross debt-to-EBITDA) by repaying debt, releasing synergies related to the KCS integration, and continuing the Company’s suspension of its share buyback program until the targeted financial metrics are achieved. Looking ahead, DBRS Morningstar anticipates the STB to approve the KCS acquisition in Q1 2023 with minimal changes and expects management to easily realize its targeted cost and revenue synergies from the KCS transaction (USD 1 billion spread evenly across 2023, 2024, and 2025). The CP-KCS combination will also be the only railroad network connecting Canada, the U.S., and Mexico. Also, it will lead to rail to rail revenue conversion through potentially faster shipping, substitution of truck freight, and new opportunities for freight shipments.

During the first nine months of 2022, CP’s revenue ton miles (RTM) declined by 4% year over year (YOY) mostly caused by lower shipments of Canadian grain, coal, and energy, chemicals, and plastics. This was partially offset by an increase in U.S. grain, potash, frac sand, and intermodal shipments. Canadian potash demand remains strong because of constrained supply chains and the Ukraine-Russia war. Both volume and pricing should remain elevated well into 2023. Canadian grain volumes were slower in the first nine months of 2022, but the forecast crop size of 75 million metric tons (top five of all-time crop harvest, and 7% better than the five-year average) and CP’s investment in high-capacity grain cars should lead to stronger shipping volumes in Q4 2022. Intermodal shipments remained strong, owing to new international customers, higher domestic volumes, and renewed contracts. Auto shipments accelerated in Q3, and the new Ford Motor Company (rated BB (high) with a Positive trend by DBRS Morningstar) contract coupled with easing supply chains will support auto shipment volumes. Despite lower RTMs, revenues appreciated by 6% YOY because of price increases across almost all segments caused by rising freight rates and fuel surcharges. RTMs also increased in Q3 (+6% YOY) and are expected to move higher for the full year and in the first half of 2023. Operating expenses rose by 11% YOY, owing to sharp increases in fuel and materials costs and a modest increase of 3% YOY in wages. Free cash flow increased 22% YOY to $1.5 billion, owing to lower capital expenditures offset by working capital outflows. CP also received $593 million in dividends from KCS and repaid $1.2 billion in debt.

Stable trends and the current ratings reflect DBRS Morningstar’s expectations that the Company will continue to show solid operational execution and deleveraging from its current high leverage. The ratings will come under pressure if credit metrics significantly deteriorate with cash flow-to-debt declining materially below 20% and/or debt-to-EBITDA increasing above 4.75x for a sustained period of time. Conversely, the ratings may be upgraded if cash flow-to-debt increases above 30% and debt-to-EBITDA moves below 2.5x, both in a sustained manner.

There were no Environmental/Social/Governance factor(s) that had a significant or relevant effect on the credit analysis.

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/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).

DBRS Morningstar notes that this press release was amended on February 27, 2023, to correct the rated entity participation status.

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

The principal methodologies are Rating Companies in the Railway Industry (January 20, 2022; https://www.dbrsmorningstar.com/research/390920), DBRS Morningstar Criteria: Commercial Paper Liquidity Support for Nonbank Issuers (March 1, 2022; https://www.dbrsmorningstar.com/research/393065), and DBRS Morningstar Criteria: Guarantees and Other Forms of Support (April 4, 2022; https://www.dbrsmorningstar.com/research/394683), which can be found on dbrsmorningstar.com under Methodologies & Criteria.

A description of how DBRS Morningstar analyzes corporate finance transactions and how the methodologies are collectively applied can be found at: https://www.dbrsmorningstar.com/research/397223/interplay-of-global-corporate-finance-rating-methodologies-when-analyzing-corporate-finance-transactions.

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 info@dbrsmorningstar.com.

This rating was not initiated at the request of the rated entity.

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.

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

DBRS Morningstar will publish a full report shortly that will provide additional analytical detail on this rating action. If you are interested in receiving this report, contact us at info@dbrsmorningstar.com.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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