DBRS Morningstar Confirms Canadian National Railway Company at “A” and R-1 (low), Stable Trends

DBRS Limited (DBRS Morningstar) confirmed Canadian National Railway Company’s (CN or the Company) Issuer Rating and Unsecured Bonds, Debentures & Notes rating at “A.” DBRS Morningstar also confirmed CN’s Commercial Paper rating at R-1 (low). All trends remain Stable. The ratings confirmations are based on CN’s long track record of solid operating performance, including for the full year 2022 and the first quarter of 2023. The Stable trends reflect DBRS Morningstar’s expectation that, while operating results could be pressured by the economic slowdown and credit metrics will moderate as the Company intends to increase its capital expenditures (capex) and returns to shareholders, such that debt-to-EBITDA leverage increases to 2.5 times (x) over time, the Company’s overall credit risk profile remains acceptable for the current rating category. CN’s ratings continue to be underpinned by an extensive network, diversified product and customer base, high operating efficiency, a strong cash flow generative profile, and the relative importance of the sector in which it operates to the broader economy. These advantages are balanced by the high capital intensity of the railway industry, regulatory focus on safety and service, and a mature industry with modest long-term growth relative to other cyclical industries.

On April 11, 2022, DBRS Morningstar confirmed CN’s ratings at “A” with Stable trends. At the time, DBRS Morningstar stated that an erosion in leverage caused by weaker earnings and/or higher debt to fund shareholder distributions or a change in CN’s target leverage range, such that cash flow-to-debt declines below 35% and debt-to-EBITDA increases above 2.0x on a sustained basis, could lead to a negative rating action. Since then, Company has reported strong operating results, with revenue increasing to more than $17 billion (+18% year over year (YOY)) in 2022 and EBITDA growing to above $8.5 billion (+19% YOY) in 2022 driven by increased volumes and better pricing. The growth in EBITDA translated into strong cash flow generation with free cash flow increasing to approximately $2 billion (+12% YOY), which the Company, in combination with $2 billion in incremental debt, primarily used for share buy backs. As such, despite the increase in debt, credit metrics remained relatively stable with debt-to-EBITDA leverage increasing to 1.82x in 2022 from 1.76x in 2021 and EBITDA interest coverage of 15.6x in 2022 versus 11.9x in 2021.

Looking ahead, DBRS Morningstar expects revenue to grow in the mid-single digits toward $18 billion in 2023, supported by volume growth and price increases ahead of inflation. DBRS Morningstar forecast EBITDA to increase to above $9 billion in 2023 and cash flow generation to remain strong with free cash flow growing to above $2.5 billion. Capex is set to increase above $3 billion as the Company plans to continue to invest in its networks. DBRS Morningstar anticipates the Company to use its free cash flow in combination with incremental debt for share buy backs. As such, DBRS Morningstar forecasts credit metrics to soften with debt-to-EBITDA leverage increasing to above 2.0x. Over the near to medium term, DBRS Morningstar expects management to follow through on its announcement to use further incremental debt issuance for additional share buy backs, such that the Company’s debt-to-EBITDA leverage increases to 2.5x over time.

While DBRS Morningstar views the increase in CN’s leverage as having a negative effect on the Company’s overall credit risk profile, DBRS Morningstar notes both the material improvement in the Company’s business risk profile over the past few years and the further expected strengthening of the same over the near to medium term. In particular, this includes the recently announced partnership with Union Pacific (UP) and GMXT to create a premium intermodal offering connecting Canada, Mexico, and the U.S. through a seamless rail connection in Chicago, materially improving the Company’s network quality and diversification of the goods carried through the network. DBRS Morningstar believes that the new service offers meaningful time savings to end customers versus a comparable service by competitors. The new service should furthermore also help displace long distance trucking from Mexico to and from the U.S./Canada in favor of the more efficient train service. Additionally, the planned Port Terminal expansions at Halifax; Contrecoeur, Québec; Vancouver; Prince Rupert, British Columbia; and New Orleans should also serve as a catalyst for future growth. DBRS Morningstar also notes CN’s long track record of continuously investing in the business to achieve improved superior levels of safety and service. This is evidenced by a solid multiyear safety record and continuously improving operating and efficiency metrics, which further translate into better margins.

As such, DBRS Morningstar believes that the continued improvement in the Company’s business risk profile serves as a partial offset to the increase in leverage and weaker financial risk profile, such that the Company’s overall credit risk profile remains acceptable for the current rating category. That said, should credit metrics deteriorate any further for a sustained period (i.e., debt-to-EBITDA increase above 2.5x) as a result of either weaker-than-expected operating performance and/or more aggressive financial management, the ratings could be pressured. Furthermore, DBRS Morningstar notes, that weaker-than-expected operating performance for a sustained period, resulting in a more permanent shift of the Company's business risk profile, could also result in the requirement to maintain stronger credit metrics to support the same rating.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
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-riskfactors-in-credit-ratings (May 17, 2022).

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

DBRS Morningstar applied the following principal methodology:
-- Global Methodology for Rating Companies in the Railway Industry (March 28, 2023) - https://www.dbrsmorningstar.com/research/411571/global-methodology-for-rating-companies-in-the-railway-industry

The following methodologies have also been applied:
-- DBRS Morningstar Global Criteria: Commercial Paper Liquidity Support for Nonbank Issuers (February 24, 2023) - https://www.dbrsmorningstar.com/research/410196/dbrs-morningstar-global-criteria-commercial-paper-liquidity-support-for-nonbank-issuers
-- DBRS Morningstar Global Criteria: Guarantees and Other Forms of Support (March 28, 2023) - https://www.dbrsmorningstar.com/research/411694/dbrs-morningstar-global-criteria-guarantees-and-other-forms-of-support

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

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.

The rating was 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 had access to the accounts, management and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

This is a solicited credit rating.

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.

Information regarding DBRS Morningstar ratings, including definitions, policies, and methodologies, is available on www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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