DBRS Morningstar Changes Trend on Canadian Pacific Railway Company to Positive From Stable, Confirms Credit Ratings at BBB

DBRS Limited (DBRS Morningstar) changed the trends on Canadian Pacific Railway Company’s (CP) Issuer Rating and Unsecured Debentures rating to Positive from Stable and confirmed the credit ratings at BBB. DBRS Morningstar also discontinued and withdrew the Company’s Commercial Paper rating. The discontinuation does not reflect any change in DBRS Morningstar’s view of the Company’s credit quality. The trend changes reflect the steadily improving financial profile with leverage projected to decline close to 3.0 times (x) in 2024 and the declining risk of the Kansas City Southern (KCS) integration outweighing the potential risk of an economic slowdown. The credit ratings continue to reflect CP’s significant credit strengths, which include a well-positioned railroad network, high network efficiency, solid operational execution, and experienced management. The credit ratings also continue to consider the high capital intensity of the railway industry, regulatory focus on safety and service, potential of an economic slowdown, and a mature industry with fewer growth opportunities relative to other cyclical industries.

On December 14, 2022, DBRS Morningstar confirmed the Company’s Issuer Rating and Unsecured Debentures rating at BBB with Stable trends. At that time, DBRS Morningstar flagged the risks related to the Surface Transportation Board’s (STB) potential approval for the KCS acquisition and the subsequent integration risk. DBRS Morningstar also stated that the Company had to deleverage debt-to-EBITDA to 2.5x for the credit ratings to revert to the pre-KCS acquisition level of BBB (high).

Since then, the Company has received approval for its KCS acquisition from STB. CP has not only strongly executed across its network but also worked on integrating KCS. The Company has reported two quarters of combined results and expects to end the year with more than US$ 350 million in annualized revenue synergies. Combined revenues for the three quarters ended September 2023 (9M 2023) improved to $9.9 billion from $9.4 billion during the corresponding period in 2022. Most segments reflected growth except for Potash and Intermodal, the former because of outage at an export facility in Portland and the latter owing to labour action at the Port of Vancouver. For the same period, operating ratios marginally weakened by 130 basis points (bps) to 63.3% owing to the KCS integration costs, competitive pressures from the trucking industry, and the incorporation of the higher operation ratio of KCS.

Cash flow from operations (as defined by DBRS Morningstar) improved to $3.0 billion during 9M 2023 from $2.7 billion the year prior. After accounting for the higher capital expenditures (capex) of $1.8 billion versus $1 billion and unchanged dividends at $530 million, free cash flow (before working capital) declined to $706 million for 9M 2023 relative to $1.2 billion during 9M 2022. Coupled with management’s decision to defer share repurchases until the Company achieves its target leverage of 2.5x, this resulted in the Company’s debt-to-EBITDA leverage improving to below 3.7x for the last 12 months ended September 30, 2023 (Q3 2023) from above 5.0x following the KCS acquisition.

Looking ahead, DBRS Morningstar expects CP to post revenues above $12.0 billion in 2023 and comfortably ahead of $13.0 billion in 2024. This revenue increase should be supported by volume growth and slowing price increases. DBRS Morningstar forecasts EBITDA to be above $5.0 billion in 2023 and above $5.5 billion in 2023 and cash flow generation to remain strong with free cash flow growing to above $1.3 billion in 2023 and to north of $1.5 billion in 2024. Capex is set to average at $2.7 billion as the Company continues to spend on growth initiatives and maintenance of its networks. DBRS Morningstar anticipates the Company will use its free cash flow primarily for debt reduction. As such, DBRS Morningstar forecasts credit metrics to further strengthen with debt-to-EBITDA leverage improving toward 3.5x by YE2023 and close to 3.0x in 2024.

DBRS Morningstar believes that the continued improvement in the Company’s financial risk profile (i.e., debt-to-EBITDA leverage declining to comfortably below 3.5x), coupled with declining integration risk of the KCS acquisition, should support an upgrade of the ratings over the next six to 12 months. While previously DBRS Morningstar required the Company to maintain debt-to-EBITDA leverage below 2.5x for a BBB (high) rating, given the strengthening of the Company’s business risk profile including as a result of the KCS acquisition, DBRS Morningstar now views debt-to-EBITDA leverage comfortably below 3.5x as commensurate of a BBB (high) rating. Although highly unlikely over the medium term, DBRS Morningstar could revert the trend to Stable should weaker-than-expected operating performance for a prolonged period and/or more aggressive shareholder remuneration keep leverage above 3.5x for an extended period of time.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors 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/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (July 4, 2023).

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 - https://www.dbrsmorningstar.com/research/411571/global-methodology-for-rating-companies-in-the-railway-industry (March 28, 2023).

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.

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

The rated entity or its related entities did not participate in the credit rating process for this credit rating action.

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

This is an unsolicited 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 credit ratings are under regular surveillance.

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

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