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Canadian Pacific Announces Second-Quarter 2012 Results

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CALGARY, July 25, 2012 /PRNewswire/ - Canadian Pacific Railway Limited (TSX: CP) (NYSE: CP) announced its second-quarter 2012 results today with reported net income of $103 million and diluted earnings per share of $0.60, inclusive of the negative impact of approximately $0.30 from significant items including management transition and advisory costs and an Ontario corporate income tax rate change.  In addition, the nine-day strike is estimated to have reduced diluted earnings per share by $0.25 to $0.30.

For the first half of 2012 Canadian Pacific's net income was $245 million, an increase of $83 million, or 51 per cent and diluted earnings per share of $1.42, an increase of $0.47, or 49 per cent.  These increases were primarily due to increased volumes and improved operating performance.

SECOND-QUARTER 2012 RESULTS COMPARED WITH SECOND-QUARTER 2011

  • Total revenues were $1.4 billion, an increase of $101 million
  • Operating expenses were $1.1 billion, an increase of $93 million
  • Average fuel price was essentially flat at $3.49 U.S. dollars per U.S. gallon compared to $3.50 U.S. dollars per U.S. gallon
  • Operating income was $239 million, an increase of $8 million
  • Operating ratio was 82.5 per cent, an increase of 80 basis points
  • Net income was $103 million, a decrease of $25 million
  • Diluted earnings per share were $0.60 per share, a decrease of $0.15 per share

Canadian Pacific's newly appointed President and Chief Executive Officer, E. Hunter Harrison said, "I look forward to working with a solid team of dedicated railroaders to improve CP's service offering and drive long-term shareholder value.  Canadian Pacific is a strong franchise with positive market opportunities."

Conference Call Information

CP will discuss its results with analysts in a conference call beginning at 1:00 p.m. Eastern time (11:00 a.m. Mountain time) on July 25, 2012.

Conference Call Access
Toronto participants dial in number: (647) 427-7450
Operator assisted toll free dial in number: 1-888-231-8191
Callers should dial in 10 minutes prior to the call.

Webcast
For those with Internet access we encourage you to listen via CP's website. To access the webcast and the presentation material, click on "Invest In CP" tab.

A replay of the conference call will be available by phone through August 22, 2012 at 416-849-0833 or toll free 1-855-859-2056, password 91414131. A webcast of the presentation and an audio file will be available at www.cpr.ca under "Invest In CP" tab.

About Canadian Pacific
Canadian Pacific (CP: TSX)(NYSE: CP) operates a North American transcontinental railway providing freight transportation services, logistics solutions and supply chain expertise. Incorporating best-in-class technology and environmental practices, CP is re-defining itself as a modern 21st century transportation company built on safety, service reliability and operational efficiency. Visit www.cpr.ca to learn more.

CONSOLIDATED STATEMENTS OF INCOME     
(in millions of Canadian dollars, except per share data)
(unaudited)

            For the three months     For the six months
            ended June 30     ended June 30
            2012     2011     2012     2011
Revenues                                    
  Freight       $   1,332    $   1,233    $   2,672    $   2,368 
  Other           34        32        70        60 
Total revenues           1,366        1,265        2,742        2,428 
Operating expenses                                    
  Compensation and benefits (Note 11)           366        337        757        701 
  Fuel           242        237        511        463 
  Materials           57        57        121        129 
  Equipment rents           56        54        106        105 
  Depreciation and amortization           135        122        262        244 
  Purchased services and other (Notes 10 and 11)           271        227        472        446 
Total operating expenses           1,127        1,034        2,229        2,088 
Operating income           239        231        513        340 
Less:                                    
  Other income and charges           19        (5)       32        (6)
  Net interest expense            69        63        138        127 
                                       
Income before income tax expense           151        173        343        219 
                                       
Income tax expense (Note 3)           48        45        98        57 
Net income       $   103    $   128    $   245    $   162 
                                       
Earnings per share (Note 4)                                    
  Basic earnings per share       $   0.60    $   0.76    $   1.43    $   0.96 
  Diluted earnings per share       $   0.60    $   0.75    $   1.42    $   0.95 
                                       
Weighted-average number of shares (millions)                                    
  Basic           171.1        169.4        170.8        169.3 
  Diluted           172.4        170.7        172.2        170.6 
                                       
Dividends declared per share       $   0.3500    $   0.3000    $   0.6500    $   0.5700 
                                       
See Notes to Interim Consolidated Financial Statements.                                    
                                     
                                     
                                       

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(in millions of Canadian dollars)
(unaudited)

              For the three months   For the six months
              ended June 30   ended June 30
            2012   2011   2012   2011
                                         
Net income       $   103    $   128    $   245    $   162 
                                         
  Net loss in foreign currency translation                                     
    adjustments, net of hedging activities           (7)       (2)       (2)      
                                           
  Change in derivatives designated as cash flow hedges           (8)       (7)             (3)
                                           
  Change in defined benefit pension and post-retirement                                     
    plans           54        40        108        76 
                                           
  Other comprehensive income before income taxes           39        31        108        73 
                                           
  Income tax expense           (4)       (11)       (28)       (31)
                                           
Other comprehensive income           35        20        80        42 
                                           
Comprehensive income       $   138    $   148    $   325    $   204 
                                         
See Notes to Interim Consolidated Financial Statements.                                    
                                     
                                     
         

CONSOLIDATED BALANCE SHEETS
(in millions of Canadian dollars)
(unaudited)

              June 30     December 31 
              2012     2011 
Assets                        
Current assets                        
  Cash and cash equivalents        $         82    $ 47 
  Accounts receivable, net                 497      518 
  Materials and supplies                 151      138 
  Deferred income taxes                 175      101 
  Other current assets                 69      52 
                      974      856 
                             
Investments                 138      167 
Net properties                 12,964      12,752 
Goodwill and intangible assets                  192      192 
Other assets                  138      143 
Total assets       $         14,406    $ 14,110 
                             
Liabilities and shareholders' equity                        
Current liabilities                        
  Short-term borrowing       $           $ 27 
  Accounts payable and accrued liabilities                 1,101      1,133 
  Long-term debt maturing within one year                 52      50 
                      1,153      1,210 
                             
Pension and other benefit liabilities (Note 8)                 1,240      1,372 
Other long-term liabilities                 313      365 
Long-term debt (Note 5)                 4,745      4,695 
Deferred income taxes                 2,017      1,819 
Total liabilities                 9,468      9,461 
                             
Shareholders' equity                        
  Share capital                 1,934      1,854 
  Additional paid-in capital                  81      86 
  Accumulated other comprehensive loss                 (2,656)     (2,736)
  Retained earnings                 5,579      5,445 
                      4,938      4,649 
Total liabilities and shareholders' equity       $         14,406    $ 14,110 
                             
Commitments and contingencies (Note 9)                        
See Notes to Interim Consolidated Financial Statements.                        
                             
                             
                           

CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions of Canadian dollars)
(unaudited)

              For the three months   For the six months
              ended June 30   ended June 30
                2012   2011   2012   2011
Operating activities                                    
  Net income       $   103    $   128    $   245    $   162 
    Reconciliation of net income to cash provided by                                    
    operating activities:                                    
      Depreciation and amortization           135        122        262        244 
      Deferred income taxes (Note 3)           48        52        94        60 
      Pension funding in excess of expense (Note 8)           (23)       (13)       (30)       (24)
      Other operating activities, net                   (15)       (23)       (13)
      Change in non-cash working capital balances related to                                     
      operations            57        (61)       (21)       (81)
Cash provided by operating activities           326        213        527        348 
                                           
Investing activities                                    
  Additions to properties           (292)       (219)       (525)       (352)
  Proceeds from the sale of properties and other assets (Note 6)           17        15        62        21 
  Other                 (1)       (1)       (1)
Cash used in investing activities           (275)       (205)       (464)       (332)
                                           
Financing activities                                    
  Dividends paid           (51)       (46)       (102)       (92)
  Issuance of common shares           17              55        11 
  Issuance of long-term debt (Note 5)                       71       
  Repayment of long-term debt           (13)       (6)       (25)       (18)
  Net decrease in short-term borrowing                       (27)      
Cash used in financing activities           (47)       (50)       (28)       (99)
                                           
Effect of foreign currency fluctuations on U.S. dollar-                                    
denominated cash and cash equivalents                 (1)             (10)
Cash position                                    
  Increase (decrease) in cash and cash equivalents                 (43)       35        (93)
  Cash and cash equivalents at beginning of period            77        311        47        361 
Cash and cash equivalents at end of period       $   82    $   268    $   82    $   268 
                                           
Supplemental disclosures of cash flow information:                                    
  Income taxes (refunded) paid        $   (11)   $     $   (7)   $  
  Interest paid       $   83    $   91    $   134    $   140 
                                           
See Notes to Interim Consolidated Financial Statements.                                    
                                           
                                           
                 

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(in millions of Canadian dollars, except common share amounts)
(unaudited)

        Common                  Accumulated               
        shares            Additional    other            Total 
        (in    Share    paid-in    comprehensive    Retained    shareholders' 
        millions)    capital    capital    loss    earnings    equity 
Balance at January 1, 2012     170.0    $   1,854    $ 86    $ (2,736)   $   5,445    $ 4,649 
Net income                          245      245 
Other comprehensive income                   80            80 
Dividends declared                         (111)     (111)
Effect of stock-based compensation expense               18                18 
Shares issued under stock option plans     1.3        80      (23)               57 
Balance at June 30, 2012     171.3    $   1,934    $ 81    $ (2,656)   $   5,579    $ 4,938 
                                           
                                           
        Common                  Accumulated               
        shares            Additional    other            Total 
        (in    Share    paid-in    comprehensive    Retained    shareholders' 
        millions)    capital    capital    loss    earnings    equity 
Balance at January 1, 2011     169.2    $   1,813    $ 24    $ (2,086)   $   5,073    $ 4,824 
Net income                          162      162 
Other comprehensive income                   42            42 
Dividends declared                         (97)     (97)
Effect of stock-based compensation expense               11                11 
Changes to stock-based compensation
awards (Note 7)
              52                52 
Shares issued under stock option plans     0.2        13      (2)               11 
Balance at June 30, 2011     169.4    $   1,826    $ 85    $ (2,044)   $   5,138    $ 5,005 
                                           
See Notes to Interim Consolidated Financial Statements.                                  
                                           
                                         
                                           

CANADIAN PACIFIC RAILWAY LIMITED 

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2012
(unaudited)

1  Basis of presentation

These unaudited interim consolidated financial statements of Canadian Pacific Railway Limited ("CP", or "the Company") reflect management's estimates and assumptions that are necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America ("GAAP").  They do not include all disclosures required under GAAP for annual financial statements and should be read in conjunction with the 2011 consolidated financial statements.  The accounting policies used are consistent with the accounting policies used in preparing the 2011 consolidated financial statements.

CP's operations can be affected by seasonal fluctuations such as changes in customer demand and weather-related issues.  This seasonality could impact quarter-over-quarter comparisons.

In management's opinion, the unaudited interim consolidated financial statements include all adjustments (consisting solely of normal recurring adjustments) necessary to present fairly such information.  Interim results are not necessarily indicative of the results expected for the fiscal year.

2  Accounting changes

Fair value measurement
In May 2011, the Financial Accounting Standards Board ("FASB") issued amended guidance on fair value measurement which updates some of the measurement guidance and includes enhanced disclosure requirements.  The amended guidance is effective for interim and annual periods beginning after December 15, 2011.  The adoption did not impact the results of operations or financial position but resulted in increased note disclosure (see Note 6).

Other comprehensive income
In June 2011, the FASB issued an accounting standard update on the Presentation of Comprehensive Income, which eliminates the current option to report other comprehensive income and its components in the Consolidated Statement of Changes in Shareholders' Equity.  The Company has elected to present items of net income and other comprehensive income in two separate, but consecutive, statements as opposed to one continuous statement.  With FASB's deferral of certain aspects of this accounting standard update in December 2011 and as the new guidance does not change those components that are recognized in net income or those components that are recognized in other comprehensive income, adoption did not impact the results of operations or financial position.

Intangibles - goodwill and other
In September 2011, the FASB issued amended guidance on the testing of goodwill for impairment.  The amendments allow an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test.  Under these amendments, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount.  The Company will consider this option when testing goodwill for impairment.  As it does not change how a goodwill impairment loss is measured, the adoption of the guidance does not impact the results of operations and financial position.

3  Income taxes

During the three months ended June 30, 2012, legislation was enacted to cancel the previously planned province of Ontario's corporate income tax rate reductions.  As a result of these changes, the Company recorded an income tax expense of $11 million in the quarter, based on its deferred income tax balances as at December 31, 2011.

              For the three months   For the six months
              ended June 30   ended June 30
  (in millions of Canadian dollars)           2012   2011   2012   2011
  Current income tax expense            $         $       (7)   $         $       (3)
  Deferred income tax expense                    48            52            94            60 
  Income tax expense            $       48    $       45    $       98    $       57 
                                                           

The effective income tax rate for the three and six months ended June 30, 2012 was 31.8% and 28.6% respectively, (three and six months ended June 30, 2011 - 26.0%) as a result of the change in the province of Ontario's corporate income tax rate.

4  Earnings per share

At June 30, 2012, the number of shares outstanding was 171.3 million (June 30, 2011 - 169.4 million).

Basic earnings per share have been calculated using net income for the period divided by the weighted-average number of shares outstanding during the period.

The number of shares used in earnings per share calculations is reconciled as follows:

          For the three months    For the six months 
          ended June 30    ended June 30 
  (in millions)       2012    2011    2012    2011 
  Weighted-average shares outstanding       171.1    169.4      170.8      169.3 
  Dilutive effect of stock options       1.3    1.3      1.4      1.3 
  Weighted-average diluted shares outstanding       172.4    170.7      172.2      170.6 
                           

For the three and six months ended June 30, 2012, 388,067 and 313,000 options, respectively, were excluded from the computation of diluted earnings per share because their effects were not dilutive (three and six months ended June 30, 2011 - 2,023,500 and 1,456,021, respectively).

5  Long-term debt

During the first quarter of 2012, the Company issued US$71 million 4.28% Senior Secured Notes due in 2027 for net proceeds of $71 million.  These Notes are secured by locomotives previously acquired by the Company with a carrying value of $71 million at June 30, 2012.  The Company pays equal blended semi-annual payments of principal and interest up to and including March 2027.  Final repayment of the remaining principal of US$35 million is due in March 2027.

6  Financial instruments

A.  Fair values of financial instruments

GAAP establishes a fair value hierarchy that prioritizes, with respect to reliability, the inputs to valuation techniques used to measure fair value. This hierarchy consists of three broad levels.  Level 1 inputs consist of quoted prices (unadjusted) in active markets for identical assets and liabilities and have the highest priority.  Level 2 and 3 inputs are based on significant other observable inputs and significant unobservable inputs, respectively, and have lower priorities.

When possible, the estimated fair value is based on quoted market prices and, if not available, estimates from third party brokers.  For non-exchange traded derivatives classified in Level 2, the Company uses standard valuation techniques to calculate fair value. Primary inputs to these techniques include observable market prices (interest, foreign exchange and commodity) and volatility, depending on the type of derivative and nature of the underlying risk.  The Company uses inputs and data used by willing market participants when valuing derivatives and considers its own credit default swap spread as well as those of its counterparties in its determination of fair value.

The carrying values of financial instruments equal or approximate their fair values with the exception of long-term debt which has a fair value of approximately $5,632 million at June 30, 2012 (December 31, 2011 - $5,314 million) with a carrying value of $4,797 million (December 31, 2011 - $4,745 million).  The estimated fair value of current and long-term borrowings has been determined based on market information where available, or by discounting future payments of interest and principal at estimated interest rates expected to be available to the Company at period end.  All derivatives and long-term debt are classified as Level 2.

A detailed analysis of the techniques used to value long-term floating rate notes, which are classified as Level 3, is discussed below:

Long-term floating rate notes

During the first quarter of 2012, the Company sold all of its Master Asset Vehicle ("MAV") 2 Class A-2 Notes which had a carrying value of $33 million (original cost - $46 million) for proceeds and interest of $33 million.

At June 30, 2012, the Company's investment in MAV 2 Class A-1 Notes has a carrying value, being the estimated fair value of the notes, reported in "Investments" of $48 million (original cost - $59 million).  During June 2012, DBRS upgraded the rating of the Notes from A (high) to AA (low).

Accretion and other minor changes in market assumptions resulted in net unrealized income of $1 million and $2 million in the three and six months ended June 30, 2012, respectively (three and six months ended June 30, 2011 - gains of $9 million and $10 million, respectively) which were reported in "Other income and charges".

The valuation technique and assumptions used by the Company to estimate the fair value of its investment in long-term floating rate notes at June 30, 2012 and December 31, 2011, incorporates probability weighted discounted cash flows considering the best available public information regarding market conditions and other factors that a market participant would consider for such investments.  The valuation of the Notes is prepared by the Company's Treasury department and results are reviewed by senior finance officials, at a minimum, on a quarterly basis.  The Notes at June 30, 2012, are expected to mature in January 2017 and are modelled using an average coupon interest rate of 0.8%, a discount rate of 4.8%, and assumed no credit losses.  Similar assumptions were modelled at December 31, 2011, with the exception of the discount rate which was 6.1%.

Changes in the fair value of the Notes resulting from a 50 basis point increase/decrease in the coupon interest rate or discount rate would have a negligible impact on earnings during the three and six months ended June 30, 2012 and 2011.

B.  Financial risk management

The Company's policy with respect to using derivative financial instruments is to selectively reduce volatility associated with fluctuations in interest rates, foreign exchange ("FX") rates, the price of fuel and stock-based compensation expense.  Where derivatives are designated as hedging instruments, the relationship between the hedging instruments and their associated hedged items is documented, as well as the risk management objective and strategy for the use of the hedging instruments.  This documentation includes linking the derivatives that are designated as fair value or cash flow hedges to specific assets or liabilities on the Consolidated Balance Sheet, commitments or forecasted transactions.  At the time a derivative contract is entered into, and at least quarterly thereafter, an assessment is made whether the derivative item is effective in offsetting the changes in fair value or cash flows of the hedged items.  The derivative qualifies for hedge accounting treatment if it is effective in substantially mitigating the risk it was designed to address.

It is not the Company's intent to use financial derivatives or commodity instruments for trading or speculative purposes.

Foreign exchange management
The Company is exposed to fluctuations of financial commitments, assets, liabilities, income or cash flows due to changes in FX rates.  The Company conducts business transactions and owns assets in both Canada and the United States; as a result, revenues and expenses are incurred in both Canadian and U.S. dollars.  The Company enters into foreign exchange risk management transactions primarily to manage fluctuations in the exchange rate between Canadian and U.S. currencies.  In terms of net income, excluding FX on long-term debt, mitigation of U.S. dollar FX exposure is provided primarily through offsets created by revenues and expenses incurred in the same currency.  Where appropriate, the Company negotiates with customers and suppliers to reduce the net exposure.

Occasionally the Company will enter into short-term FX forward contracts as part of its cash management strategy.

Net investment hedge
The FX gains and losses on long-term debt are mainly unrealized and can only be realized when U.S. dollar denominated long-term debt matures or is settled. The Company also has long-term FX exposure on its investment in U.S. affiliates. The majority of the Company's U.S. dollar denominated long-term debt has been designated as a hedge of the net investment in foreign subsidiaries. This designation has the effect of mitigating volatility on net income by offsetting long-term FX gains and losses on U.S. dollar denominated long-term debt and gains and losses on its net investment. The effective portion recognized in "Other comprehensive income" for the three and six months ended June 30, 2012 was an unrealized foreign exchange loss of $66 million and $6 million, respectively (three and six months ended June 30, 2011 - unrealized gain of $16 million and $90 million, respectively).  There was no ineffectiveness for the three and six months ended June 30, 2012, and comparative periods.

Foreign exchange forward contracts
The Company may enter into FX forward contracts to lock-in the amount of Canadian dollars it has to pay on its U.S. denominated debt maturities.

At June 30, 2012, the Company had FX forward contracts to fix the exchange rate on US$50 million of principal outstanding on a capital lease due in January 2014, US$175 million of its 6.50% Notes due in May 2018, and US$100 million of its 7.25% Notes due in May 2019.  At June 30, 2011, the Company had FX forward contracts to fix the exchange rate on US$101 million of its 5.75% 2013 Notes due in May 2013, US$175 million of its 6.50% Notes due in May 2018, and US$100 million of its 7.25% Notes due in May 2019.  These derivatives, which are accounted for as cash flow hedges, guarantee the amount of Canadian dollars that the Company will repay when these obligations mature.

During the three and six months ended June 30, 2012, an unrealized foreign exchange gain of $5 million and $1 million, respectively (three months and six months ended June 30, 2011 - unrealized loss of $1 million and $5 million, respectively) was recorded in "Other income and charges" in relation to these derivatives.  These gains in 2012 recorded in "Other income and charges" were largely offset by the unrealized losses on the underlying debt which the derivatives were designated to hedge. Similarly, the losses in 2011 were largely offset by the unrealized gains on the underlying debt.

At June 30, 2012, the unrealized gain derived from these FX forwards was $12 million which was included in "Other assets" with the offset reflected as an unrealized gain of $4 million in "Accumulated other comprehensive loss" and as an unrealized gain of $8 million in "Retained earnings".  At December 31, 2011, the unrealized gain derived from these FX forwards was $6 million which was included in "Other assets" with the offset reflected as an unrealized loss of $1 million in "Accumulated other comprehensive loss" and as an unrealized gain of $7 million in "Retained earnings".

At June 30, 2012, the Company expected that, during the next twelve months, unrealized pre-tax losses of $2 million would be reclassified to "Other income and charges".

Interest rate management
The Company is exposed to interest rate risk, which is the risk that the fair value or future cash flows of a financial instrument will vary as a result of changes in market interest rates. In order to manage funding needs or capital structure goals, the Company enters into debt or capital lease agreements that are subject to either fixed market interest rates set at the time of issue or floating rates determined by on-going market conditions.  Debt subject to variable interest rates exposes the Company to variability in interest expense, while debt subject to fixed interest rates exposes the Company to variability in the fair value of debt.

To manage interest rate exposure, the Company accesses diverse sources of financing and manages borrowings in line with a targeted range of capital structure, debt ratings, liquidity needs, maturity schedule, and currency and interest rate profiles. In anticipation of future debt issuances, the Company may enter into forward rate agreements such as treasury rate locks, bond forwards or forward starting swaps, designated as cash flow hedges, to substantially lock in all or a portion of the effective future interest expense.  The Company may also enter into swap agreements, designated as fair value hedges, to manage the mix of fixed and floating rate debt.

At June 30, 2012 and December 31, 2011, the Company had no outstanding interest rate swaps.

Stock-based compensation expense management

Total Return Swaps ("TRS")
The Company is exposed to stock-based compensation risk, which is the probability of increased compensation expense due to the increase in the Company's share price.

The Company has a TRS to reduce the volatility to the Company over time on three types of stock-based compensation programs: Tandem share appreciation rights ("TSARs"), Deferred share units ("DSUs"), and Restricted share units ("RSUs").  As the Company's share price appreciates, these programs create increased compensation expense.  The TRS is a derivative that provides a gain to offset increased compensation expense as the share price increases and a loss to offset reduced compensation expense when the share price falls.  This derivative is not designated as a hedge and changes in fair value are recognized in net income in the period in which the change occurs.

During the six months ended June 30, 2012, the Company reduced the size of the TRS program by 0.3 million share units for proceeds of $1 million.  During the same period of 2011 the program was reduced by 0.5 million share units at minimal cost.  At June 30, 2012, the Company had 0.3 million share units (December 31, 2011 - 0.6 million) remaining in the TRS.

Fuel price management
The Company is exposed to commodity risk related to purchases of diesel fuel and the potential reduction in net income due to increases in the price of diesel.  Fuel expense constitutes a large portion of the Company's operating costs and volatility in diesel fuel prices can have a significant impact on the Company's income. Items affecting volatility in diesel prices include, but are not limited to, fluctuations in world markets for crude oil and distillate fuels, which can be affected by supply disruptions and geopolitical events.

The impact of variable fuel expense is mitigated substantially through fuel cost recovery programs which apportion incremental changes in fuel prices to shippers through price indices, tariffs, and by contract, within agreed upon guidelines.  While these programs provide effective and meaningful coverage, residual exposure remains as the fuel expense risk cannot be completely recovered from shippers due to timing and volatility in the market.  The Company continually monitors residual exposure, and where appropriate, may enter into derivative instruments.

Energy futures
At June 30, 2012, the Company had diesel futures contracts, which are accounted for as cash flow hedges, to purchase approximately 20 million U.S. gallons during the period July 2012 to June 2013 at an average price of $3.01 per U.S. gallon.  This represents approximately 7% of estimated fuel purchases for this period.  At June 30, 2012, the unrealized loss on these futures contracts was $5 million (December 31, 2011 - $3 million) and was reflected in "Accounts payable and accrued liabilities" with the offset, net of tax, reflected in "Accumulated other comprehensive loss" on the Consolidated Balance Sheets.

The impact of settled commodity swaps increased "Fuel" expense by $1 million in the three months ended June 30, 2012, as a result of realized losses on diesel swaps.  During the six months ended June 30, 2012, these swaps had a negligible impact to "Fuel" expense.  During the three and six months ended June 30, 2011, these swaps decreased "Fuel" expense by $4 million and $7 million, respectively, as a result of realized gains.  At June 30, 2012, the Company expected that, during the next twelve months, $5 million of unrealized pre-tax holding losses on diesel future contracts would be realized and recognized in "Fuel" expense as a result of these derivatives being settled.

7  Stock-based compensation

At June 30, 2012, the Company had several stock-based compensation plans, including stock option plans, various cash settled liability plans, which are remeasured to fair value quarterly based on share price and vesting conditions, and an employee stock savings plan.  These plans resulted in an expense of $3 million for the three months ended June 30, 2012 and an expense of $26 million for the six months ended June 30, 2012 (three and six months ended June 30, 2011 expense of $3 million and $15 million, respectively).  Most of the stock-based compensation plans include a provision whereby vesting is accelerated should certain changes in the composition of the Board of Directors occur.  These provisions were triggered on June 26, 2012 and the recognition of the revised vesting terms as outlined in the stock-based compensation plans resulted in a credit to "Compensation and benefits" of $8 million in the second quarter of 2012.  RSUs and TSARs were not impacted by this change and for DSUs 14,080 units were subject to immediate vesting.  The impact discussed above on options and performance share units is outlined in more detail below.

Regular options
In the three months ended June 30, 2012, under CP's stock option plans, the Company issued 1,230,600 regular options, including options granted upon management transition (see Note 11) at the weighted-average price of $74.48 per share, based on the last closing price immediately prior to the grant (first six months of 2012 - 1,236,100 regular options at the weighted-average price of $74.48 per share).  Pursuant to the employee plans, these regular options vest between 12 and 48 months after the grant date, and will expire after 10 years.  Certain of these options granted are only exercisable after employment is terminated.

The recent changes to the composition of the Board triggered the immediate vesting on June 26, 2012 of all unvested regular options granted prior to 2012, 4,000 unvested options granted in 2012, and all unvested performance options.  As at June 30, 2012, 5,276,345 options are exercisable.

Under the fair value method, the fair value at the grant date of the regular options issued in the six months ended June 30, 2012 was $22 million.  The weighted-average fair value assumptions were approximately:

        For the six months
        ended June, 30 2012
                             
                             
  Grant price     $                 74.48  
  Expected option life (years) (1)                       5.99  
  Risk-free interest rate (2)                       1.48 %
  Expected stock price volatility (3)                       31 %
  Expected annual dividends per share (4)     $                 1.40  
  Expected forfeiture rate (5)                       1.00 %
  Weighted-average grant date fair value of regular options                          
  granted during the period     $                 17.66  
                             

(1) Represents the period of time that awards are expected to be outstanding.  Historical data on exercise behaviour, or when available, specific expectations regarding future exercise behaviour, were used to estimate the expected life of the option.
(2) Based on the implied yield available on zero-coupon government issues with an equivalent remaining term at the time of the grant.
(3) Based on the historical stock price volatility of the Company's stock over a period commensurate with the expected term of the option.
(4) Determined by the current annual dividend at the time of grant.  The Company does not employ different dividend yields throughout the contractual term of the option.
(5) The Company estimated forfeitures based on past experience.  This rate is monitored on a periodic basis.

Performance share unit ("PSU") plan
In the first six months of 2012, the Company issued 278,670 PSUs with a grant date fair value of $21 million.  These units attract dividend equivalents in the form of additional units based on the dividends paid on the Company's Common Shares.  PSUs vest and are settled in cash approximately three years after the grant date contingent upon CP's performance (performance factor).  The fair value of PSUs is measured, both on the grant date and each subsequent quarter until settlement, using a Monte Carlo simulation model.  The model utilizes multiple input variables that determine the probability of satisfying the performance and market conditions stipulated in the grant.

Recent changes to the Board also resulted in the immediate vesting of a pro-rata portion of all unvested PSUs during the second quarter of 2012.  The number of units that vested was based on the number of months of the total performance period that had passed and the fair value of the units to be settled was based on the average closing price of the 30 trading days prior to June 26, 2012.  The payout of $32 million will occur in the third quarter of 2012.

The performance period for the first grant of PSUs issued in 2009 ended December 31, 2011.  These PSUs are earned based on the Total Shareholder Return ("TSR") compared to the S&P/TSX60 index, and Return on Capital Employed ("ROCE").  The TSR for the three-year period exceeded target, while ROCE targets were not met.  The TSR component of the plan resulted in a total PSU payout equal to 200% for half of the award, in effect resulting in a target payout.  The payout of $24 million occurred in March 2012 and was calculated using the Company's average share price during the last 30 trading days ending on December 31, 2011.

Tandem share appreciation rights ("TSARs")
As a result of changes to Canadian tax legislation, which eliminated the favourable tax treatment on cash settled compensation awards, the Company offered employees the option of cancelling the outstanding SAR and keeping in place the outstanding option.  During the first quarter of 2011, the Company cancelled 3.1 million SARs and reclassified the fair value of the previously recognized liability ($70 million) and the recognized deferred tax asset ($18 million) to "Additional paid-in capital".  The terms of the awards were not changed and as a result no incremental cost was recognized.  The weighted average fair value of the units cancelled during the first quarter of 2011 was $25.36 per unit.

8  Pensions and other benefits

In the three and six months ended June 30, 2012, the Company made contributions of $33 million and $50 million, respectively (2011 - $24 million and $47 million, respectively) to its defined benefit pension plans.  The elements of net periodic benefit cost for defined benefit pension plans and other benefits recognized in the three and six months ended June 30, 2012, included the following components:

            For the three months  
            ended June 30  
            Pensions     Other benefits  
  (in millions of Canadian dollars)         2012     2011     2012     2011  
                                             
                                           
  Current service cost (benefits                                          
     earned by employees in the                                          
     period)       $   33    $   26    $       $      
  Interest cost on benefit obligation           113        115                   
  Expected return on fund assets           (188)       (168)                  
  Recognized net actuarial loss           52        35                   
  Amortization of prior service costs                                  
                                             
                                             
  Net periodic benefit cost       $   10    $   11    $     13    $     11   
                                             
                                             
              For the six months  
            ended June 30  
            Pensions     Other benefits  
  (in millions of Canadian dollars)         2012     2011     2012     2011  
                                             
                                             
  Current service cost (benefits                                          
     earned by employees in the                                          
     period)       $   66    $   52    $     10    $      
  Interest cost on benefit obligation           226        230          12          13   
  Expected return on fund assets           (376)       (336)                  
  Recognized net actuarial loss           104        71                   
  Amortization of prior service costs                                  
                                             
                                             
  Net periodic benefit cost       $   20    $   23    $     25    $     23   
                                           

9  Commitments and contingencies

In the normal course of its operations, the Company becomes involved in various legal actions, including claims relating to injuries and damages to property.  The Company maintains provisions it considers to be adequate for such actions.  While the final outcome with respect to actions outstanding or pending at June 30, 2012 cannot be predicted with certainty, it is the opinion of management that their resolution will not have a material adverse effect on the Company's financial position or results of operations.

At June 30, 2012, the Company had committed to total future capital expenditures amounting to $396 million and operating expenditures amounting to $1,763 million for the years 2012-2030.

Minimum payments under operating leases were estimated at $771 million in aggregate, with annual payments in each of the five years following 2012 of (in millions):  2013 - $135; 2014 - $101; 2015 - $87; 2016 - $68 and 2017 - $44.

Environmental remediation accruals cover site-specific remediation programs.  Environmental remediation accruals are measured on an undiscounted basis and are recorded when the costs to remediate are probable and reasonably estimable.

The accruals for environmental remediation represent CP's best estimate of its probable future obligation and includes both asserted and unasserted claims, without reduction for anticipated recoveries from third parties.  Although the recorded accruals include CP's best estimate of all probable costs, CP's total environmental remediation costs cannot be predicted with certainty.  Accruals for environmental remediation may change from time to time as new information about previously untested sites becomes known, environmental laws and regulations evolve and advances are made in environmental remediation technology.  The accruals may also vary as the courts decide legal proceedings against outside parties responsible for contamination.  These potential charges, which cannot be quantified at this time, are not expected to be material to CP's financial position, but may materially affect income in the particular period in which a charge is recognized.  Costs related to existing, but as yet unknown, or future contamination will be accrued in the period in which they become probable and reasonably estimable.

The expense included in "Purchased services and other" for the three and six months ended June 30, 2012 was $1 million and $1 million, respectively (three and six months ended June 30, 2011 - $1 million and $2 million, respectively).  Provisions for environmental remediation costs are recorded in "Other long-term liabilities", except for the current portion which is recorded in "Accounts payable and accrued liabilities".  The total amount provided at June 30, 2012 was $95 million (December 31, 2011 - $ 97 million).  Payments are expected to be made over 10 years to 2022.

The Dakota, Minnesota & Eastern Railroad Corporation was purchased for $1.5 billion resulting in goodwill of $150 million (US$147 million) as at June 30, 2012.  Future contingent payments of up to approximately US$1.2 billion consisting of US$441 million which would become due if construction of the Powder River Basin expansion project starts prior to December 31, 2025 and up to approximately US$777 million would become due upon the movement of specified volumes over the Powder River Basin extension prior to December 31, 2025.  Certain interest and inflationary adjustments would also become payable up to December 31, 2025 upon achievement of certain milestones.  The contingent payments would be accounted for as an increase in the purchase price.

10  Insurance recovery

In 2010, the Company suffered losses due to flooding in southern Alberta and Saskatchewan.  An amount of $12 million for business interruption insurance recoveries was recognized in "Purchased services and other" for the six months ended June 30, 2012.  In addition, in the fourth quarter of 2011 the Company recorded $5 million of insurance recoveries with respect to the same incident.

11  Management transition

On May 17, 2012, Mr. Fred Green resigned as a director from the Board of Directors and left his position as President and Chief Executive Officer of the Company. That same day, Mr. Stephen Tobias, a new Board member elected at the Company's annual shareholders meeting held on May 17, 2012, was appointed by the Board as Interim Chief Executive Officer and served in that role until June 28, 2012.

On June 28, 2012, Mr. E. Hunter Harrison was appointed by the Board as President and Chief Executive Officer.  As a result of the appointment of Mr. Harrison, the Company recorded a charge of $38 million with respect to compensation and other transition costs, including $2 million of associated costs, in the second quarter of 2012.  This charge was recorded in "Compensation and benefits" and "Purchased services and other", $16 million and $22 million, respectively.

Included in this charge were amounts totalling $16 million in respect of deferred retirement compensation for Mr. Harrison and $20 million which was payable at June 30, 2012, to Pershing Square Capital Management, L.P. ("Pershing Square") and related entities.  Pershing Square and related entities own or control approximately 14% of the Company's outstanding shares, and two Board members, Mr. William Ackman and Mr. Paul Hilal, are partners of Pershing Square.  The amount payable to Pershing Square and related entities was to reimburse them, on behalf of Mr. Harrison, for certain amounts they had previously paid to or incurred on behalf of Mr. Harrison pursuant to an indemnity in favour of Mr. Harrison in connection with losses suffered in legal proceedings commenced against Mr. Harrison by his former employer.  Reimbursement on behalf of Mr. Harrison was a precondition of Mr. Harrison accepting the Company's offer of employment.  As a result of the payment, the Company would be entitled to enforce Mr. Harrison's rights in the aforementioned legal proceedings, which will allow the Company to recover to the extent of Mr. Harrison's success in those proceedings.  The Company may also receive repayment in other circumstances in the event of certain breaches of Mr. Harrison's employment obligations to it. Mr. Harrison was also granted stock options and DSUs upon commencing employment that had a grant date fair value of $12 million (see Note 7).

In addition, the Company agreed to indemnify Mr. Harrison for certain other amounts, to a maximum of $3 million plus legal fees.  No amount has been accrued at June 30, 2012.

The Company also recorded a charge of $4 million in the second quarter of 2012 with respect to a retirement allowance for Mr. Green.


Summary of Rail Data  
                                                             
Second Quarter             Year-to-date
  2012      2011    Fav/(Unfav)     Financial (millions, except per share data)     2012      2011    Fav/(Unfav)        % 
                                                             
                            Revenues                              
$   1,332    $   1,233      $ 99         Freight revenue   $   2,672    $   2,368      $ 304    13 
    34        32               Other revenue       70        60        10    17 
    1,366        1,265        101      Total revenues       2,742        2,428        314    13 
                                                               
                                                             
                            Operating expenses                              
    366        337        (29)   (9)     Compensation and benefits       757        701        (56)   (8)
    242        237        (5)   (2)     Fuel       511        463        (48)   (10)
    57        57              Materials       121        129         
    56        54        (2)   (4)     Equipment rents       106        105        (1)   (1)
    135        122        (13)   (11)     Depreciation and amortization       262        244        (18)   (7)
    271        227        (44)   (19)     Purchased services and other       472        446        (26)   (6)
    1,127        1,034        (93)   (9)     Total operating expenses (OE)       2,229        2,088        (141)   (7)
                                                             
                                                             
    239        231              Operating income       513        340        173    51 
                                                             
                            Less:                              
                                                               
    19        (5)       (24)   -     Other income and charges       32        (6)       (38)   -
    69        63        (6)   (10)     Net interest expense       138        127        (11)   (9)
                                                               
                                                               
    151        173        (22)   (13)   Income before income tax expense       343        219        124    57 
                                                               
    48        45        (3)   (7)     Income tax expense       98        57        (41)   (72)
                                                             
                                                             
$   103    $   128      $ (25)   (20)     Net income   $   245    $   162      $ 83    51 
                                                             
                                                               
    82.5        81.7        (0.8)   (80) bps   Operating ratio (%)       81.3        86.0        4.7    470  bps
                                                             
                                                             
$   0.60    $   0.76      $ (0.16)   (21)     Basic earnings per share   $   1.43    $   0.96      $ 0.47    49 
                                                             
                                                             
$   0.60    $   0.75      $ (0.15)   (20)     Diluted earnings per share   $   1.42    $   0.95      $ 0.47    49 
                                                             
                                                             
                                                             
                            Shares Outstanding                              
                                                             
                              Weighted average number of shares                              
    171.1        169.4        1.7        outstanding (millions)       170.8        169.3        1.5   
                                                               
                              Weighted average number of diluted shares                              
    172.4        170.7        1.7        outstanding (millions)       172.2        170.6        1.6   
                                                               
                                                               
                            Foreign Exchange                              
                                                             
                              Average foreign exchange rate                              
    0.99        1.03        0.04        (US$/Canadian$)       0.99        1.02        0.03   
                                                             
                              Average foreign exchange rate                              
    1.01        0.97        0.04        (Canadian$/US$)       1.01        0.98        0.03   
                                                               
                                                               
                                                               

Summary of Rail Data (Page 2)
                                                             
Second Quarter           Year-to-date
2012    2011    Fav/(Unfav)                   2012    2011    Fav/(Unfav)        
                                                             
                            Commodity Data                            
                                                             
                              Freight Revenues (millions)                            
$ 233    $ 255    $ (22)         (9)       - Grain   $ 521    $ 487    $ 34         
  148      145                    - Coal     285      251      34          14 
  150      150                    - Sulphur and fertilizers     276      279      (3)         (1)
  306      232      74          32        - Industrial and consumer products     604      463      141          30 
  116      84      32          38        - Automotive     221      164      57          35 
  48      46                    - Forest products     98      91             
  331      321      10                - Intermodal     667      633      34         
                                                             
$ 1,332    $ 1,233    $ 99              Total Freight Revenues   $ 2,672    $ 2,368    $ 304          13 
                                                             
                              Millions of Revenue Ton-Miles (RTM)                            
  6,712      7,816      (1,104)         (14)       - Grain     15,312      15,076      236         
  5,329      5,564      (235)         (4)       - Coal     10,534      9,534      1,000          10 
  5,617      5,643      (26)               - Sulphur and fertilizers     9,659      10,512      (853)         (8)
  7,020      5,515      1,505          27        - Industrial and consumer products     14,056      11,477      2,579          22 
  658      545      113          21        - Automotive     1,317      1,068      249          23 
  1,169      1,179      (10)         (1)       - Forest products     2,384      2,471      (87)         (4)
  6,054      5,961      93                - Intermodal     12,108      11,769      339         
                                                             
  32,559      32,223      336              Total RTMs     65,370      61,907      3,463         
                                                             
                              Freight Revenue per RTM (cents)                            
  3.47      3.26      0.21                - Grain     3.40      3.23      0.17         
  2.78      2.61      0.17                - Coal     2.71      2.63      0.08         
  2.67      2.66      0.01                - Sulphur and fertilizers     2.86      2.65      0.21         
  4.36      4.21      0.15                - Industrial and consumer products     4.30      4.03      0.27         
  17.63      15.41      2.22          14        - Automotive     16.78      15.36      1.42         
  4.11      3.90      0.21                - Forest products     4.11      3.68      0.43          12 
  5.47      5.39      0.08                - Intermodal     5.51      5.38      0.13         
                                                             
  4.09      3.83      0.26              Total Freight Revenue per RTM     4.09      3.83      0.26         
                                                             
                              Carloads (thousands)                            
  91      112      (21)         (19)       - Grain     201      212      (11)         (5)
  82      81                    - Coal     160      141      19          13 
  54      54                    - Sulphur and fertilizers     96      103      (7)         (7)
  113      96      17          18        - Industrial and consumer products     228      196      32          16 
  42      37              14        - Automotive     84      73      11          15 
  16      18      (2)         (11)       - Forest products     34      36      (2)         (6)
  248      249      (1)               - Intermodal     499      492             
                                                             
  646      647      (1)             Total Carloads     1,302      1,253      49         
                                                             
                              Freight Revenue per Carload                            
$ 2,560    $ 2,277    $ 283          12        - Grain   $ 2,592    $ 2,297    $ 295          13 
  1,805      1,790      15                - Coal     1,781      1,780             
  2,778      2,778                    - Sulphur and fertilizers     2,875      2,709      166         
  2,708      2,417      291          12        - Industrial and consumer products     2,649      2,362      287          12 
  2,762      2,270      492          22        - Automotive     2,631      2,247      384          17 
  3,000      2,556      444          17        - Forest products     2,882      2,528      354          14 
  1,335      1,289      46                - Intermodal     1,337      1,287      50         
                                                             
$ 2,062    $ 1,906    $ 156              Total Freight Revenue per Carload   $ 2,052    $ 1,890    $ 162         
                                                           
                                                           
                                                           

Summary of Rail Data (Page 3)
                                               
                                               
Second Quarter       Year-to-date
  2012    2011 (1)   Fav/(Unfav)               2012    2011 (1)   Fav/(Unfav)        
                                               
                        Operations Performance                      
                                               
  1.85    1.65    (0.20)         (12)   OE per GTM (cents)(2)   1.80    1.75    (0.05)         (3)
                                               
                        OE, less land sales, fuel price impact, and CEO                      
  1.78    1.65    (0.13)         (8)         transition costs, per GTM (cents)(3)   1.75    1.76    0.01         
                                               
  16,992    16,219    (773)         (5)   Average number of active employees - Total(4)   16,490    15,567    (923)         (6)
  14,477    13,947    (530)         (4)   Average number of active employees - Expense(4)   14,717    13,978    (739)         (5)
  17,701    16,439    (1,262)         (8)   Number of employees at end of period - Total   17,701    16,439    (1,262)         (8)
  15,141    14,067    (1,074)         (8)   Number of employees at end of period - Expense   15,141    14,067    (1,074)         (8)
  41.2    54.2    13.0          24    Average daily active cars on-line (thousands)   40.5    54.7    14.2          26 
  1,057    1,114    57            Average daily active road locomotives on-line   1,045    1,088    43         
                                               
  60,926    62,763    (1,837)         (3)   Freight gross ton-miles (millions)   123,614    118,998    4,616         
  9,681    10,059    (378)         (4)   Train miles (thousands)   20,023    19,304    719         
  6,690    6,654    36            Average train weight - excluding local traffic (tons)   6,550    6,577    (27)        
  5,764    5,732    32            Average train length - excluding local traffic (feet)   5,673    5,670           
                                               
  23.7    20.0    3.7          19    Average train speed - AAR definition (mph)   24.5    19.9    4.6          23 
  18.0    20.1    2.1          10    Average terminal dwell  - AAR definition (hours)   17.7    21.8    4.1          19 
  194.2    154.3    39.9          26    Car miles per car day   201.2    146.1    55.1          38 
                                               
  164.7    164.0    0.7            Locomotive productivity (daily average GTMs/active HP)   169.7    160.8    8.9         
  4.2    4.5    (0.3)         (7)   Employee productivity (million GTMs/expense employee)   8.4    8.5    (0.1)         (1)
                                               
  1.14    1.14              Fuel efficiency(5)   1.19    1.22    0.03         
  68.8    70.2    1.4            U.S. gallons of locomotive fuel consumed (millions)(6)   145.4    143.3    (2.1)         (1)
  3.49    3.50    0.01            Average fuel price (U.S. dollars per U.S. gallon)   3.49    3.31    (0.18)         (5)
                                               
                                               
                        Safety                      
                                               
  1.26    1.76    0.50          28    FRA personal injuries per 200,000 employee-hours   1.21    1.77    0.56          32 
  1.55    1.82    0.27          15    FRA train accidents per million train-miles   1.53    2.15    0.62          29 
                                               

(1)    Certain prior period figures have been revised to conform with current presentation or have been updated to reflect new information.
(2)    Gross Ton-Mile (GTM) is the movement of the combined tons (freight car tare, inactive locomotive tare, and contents) a distance of one mile.
(3)    OE, less land sales, fuel price impact, and CEO transition costs, per GTM is calculated consistently with OE per GTM except for the exclusion of net gains on land sales, fuel price impact, the latter to remove the volatility of fuel prices and to provide comparative fuel expenses at the 2011 fuel price, and CEO transition costs.  Net gains on land sales were $3 million and $2 million for the three months ended June 30, 2012 and 2011, respectively, and $7 million and $2 million for the six months ended June 30, 2012 and 2011, respectively. The impact in fuel price was unfavourable $2 million for the three months ended June 30, 2012 and unfavourable $31 million for the six months ended June 30, 2012. CEO transition costs were $42 million for the three and six months ended June 30, 2012.
(4)    Average number of active employees total and expense have been adjusted for the strike.
(5)    Fuel efficiency is defined as U.S. gallons of locomotive fuel consumed per 1,000 GTMs - freight and yard.
(6)    Includes gallons of fuel consumed from freight, yard and commuter service but excludes fuel used in capital projects and other non-freight activities.
   

SOURCE Canadian Pacific



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