Edgar Filing: CANADIAN PACIFIC RAILWAY LTD/CN

(in millions of Canadian dollars)

September 30, 2018

December 31, 2017

Long-term debt (including current maturities):

Fair value

Carrying value

Document

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark one)


x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018


¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to

Commission File Number 001-01342

Canadian Pacific Railway Limited

(Exact name of registrant as specified in its charter)



Canada		98-0355078
(State or Other Jurisdiction of Incorporation or Organization)		(IRS Employer Identification No.)

7550 Ogden Dale Road S.E. Calgary, Alberta, Canada		T2C 4X9
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s Telephone Number, Including Area Code: (403) 319-7000

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes þ No o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes þ No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.



Large accelerated filer þ	Accelerated filer o	Non-accelerated filer o	Smaller reporting company o	Emerging growth company o

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ

As of the close of business on October 16, 2018, there were 142,601,634 of the registrant’s Common Shares issued and outstanding.

CANADIAN PACIFIC RAILWAY LIMITED

FORM 10-Q

TABLE OF CONTENTS



	PART I - FINANCIAL INFORMATION
		Page
Item 1.	Financial Statements:

	Interim Consolidated Statements of Income	2
	For the Three and Nine Months Ended September 30, 2018 and 2017

	Interim Consolidated Statements of Comprehensive Income	3
	For the Three and Nine Months Ended September 30, 2018 and 2017

	Interim Consolidated Balance Sheets	4
	As at September 30, 2018 and December 31, 2017

	Interim Consolidated Statements of Cash Flows	5
	For the Three and Nine Months Ended September 30, 2018 and 2017

	Interim Consolidated Statements of Changes in Shareholders' Equity	6
	For the Nine Months Ended September 30, 2018 and 2017

	Notes to Interim Consolidated Financial Statements	7

Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	31
	Executive Summary	31
	Performance Indicators	34
	Financial Highlights	36
	Results of Operations	37
	Liquidity and Capital Resources	51
	Share Capital	52
	Non-GAAP Measures	53
	Off-Balance Sheet Arrangements	59
	Contractual Commitments	59
	Critical Accounting Estimates	60
	Forward-Looking Information	60
Item 3.	Quantitative and Qualitative Disclosures about Market Risk	61
Item 4.	Controls and Procedures	62

	PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	63
Item 1A.	Risk Factors	63
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	63
Item 3.	Defaults Upon Senior Securities	63
Item 4.	Mine Safety Disclosures	63
Item 5.	Other Information	63
Item 6.	Exhibits	64

PART I

ITEM 1. FINANCIAL STATEMENTS

INTERIM CONSOLIDATED STATEMENTS OF INCOME

(unaudited)



	For the three months ended September 30						For the nine months ended September 30
(in millions of Canadian dollars, except share and per share data)	2018			2017			2018			2017
Revenues
Freight	$	1,854		$	1,547		$	5,188		$	4,708
Non-freight	44			48			122			133
Total revenues	1,898			1,595			5,310			4,841
Operating expenses
Compensation and benefits (Note 2, 11, 12)	365			324			1,090			969
Fuel	226			150			671			480
Materials	47			45			155			142
Equipment rents	33			35			99			108
Depreciation and amortization	174			162			516			493
Purchased services and other	263			257			822			812
Total operating expenses	1,108			973			3,353			3,004

Operating income	790			622			1,957			1,837
Less:
Other (income) expense (Note 5)	(47		)	(105		)	56			(194		)
Other components of net periodic benefit recovery (Note 2, 12)	(96		)	(68		)	(287		)	(203		)
Net interest expense	112			115			339			357
Income before income tax expense	821			680			1,849			1,877
Income tax expense (Note 6)	199			170			443			456
Net income	$	622		$	510		$	1,406		$	1,421

Earnings per share (Note 7)
Basic earnings per share	$	4.36		$	3.50		$	9.81		$	9.72
Diluted earnings per share	$	4.35		$	3.50		$	9.78		$	9.70

Weighted-average number of shares (millions) (Note 7)
Basic	142.6			145.5			143.2			146.2
Diluted	143.1			145.8			143.7			146.6

Dividends declared per share	$	0.6500		$	0.5625		$	1.8625		$	1.6250

Certain of the comparative figures have been reclassified in order to be consistent with the 2018 presentation (Note 2).

See Notes to Interim Consolidated Financial Statements.

INTERIM CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(unaudited)



	For the three months ended September 30						For the nine months ended September 30
(in millions of Canadian dollars)	2018			2017			2018			2017
Net income	$	622		$	510		$	1,406		$	1,421
Net gain (loss) in foreign currency translation adjustments, net of hedging activities	12			19			(24		)	38
Change in derivatives designated as cash flow hedges	1			2			36			11
Change in pension and post-retirement defined benefit plans	28			38			86			113
Other comprehensive income before income taxes	41			59			98			162
Income tax expense on above items	(22		)	(34		)	(11		)	(78		)
Other comprehensive income (Note 4)	19			25			87			84
Comprehensive income	$	641		$	535		$	1,493		$	1,505

See Notes to Interim Consolidated Financial Statements.

INTERIM CONSOLIDATED BALANCE SHEETS AS AT

(unaudited)



	September 30			December 31
(in millions of Canadian dollars)	2018			2017
Assets
Current assets
Cash and cash equivalents	$	150		$	338
Accounts receivable, net	759			687
Materials and supplies	156			152
Other current assets	65			97
	1,130			1,274
Investments	201			182
Properties	17,792			17,016
Goodwill and intangible assets	192			187
Pension asset	1,726			1,407
Other assets	68			69
Total assets	$	21,109		$	20,135
Liabilities and shareholders’ equity
Current liabilities
Accounts payable and accrued liabilities	$	1,189		$	1,238
Long-term debt maturing within one year (Note 8, 10)	480			746
	1,669			1,984
Pension and other benefit liabilities	746			749
Other long-term liabilities	232			231
Long-term debt (Note 8, 10)	7,806			7,413
Deferred income taxes	3,528			3,321
Total liabilities	13,981			13,698
Shareholders’ equity
Share capital	2,017			2,032
Additional paid-in capital	47			43
Accumulated other comprehensive loss (Note 4)	(1,654		)	(1,741		)
Retained earnings	6,718			6,103
	7,128			6,437
Total liabilities and shareholders’ equity	$	21,109		$	20,135

Contingencies (Note 13)

See Notes to Interim Consolidated Financial Statements.

INTERIM CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)



	For the three months ended September 30						For the nine months ended September 30
(in millions of Canadian dollars)	2018			2017			2018			2017
Operating activities
Net income	$	622		$	510		$	1,406		$	1,421
Reconciliation of net income to cash provided by operating activities:
Depreciation and amortization	174			162			516			493
Deferred income taxes (Note 6)	77			77			155			168
Pension recovery and funding (Note 12)	(84		)	(59		)	(238		)	(178		)
Foreign exchange (gain) loss on long-term debt (Note 5)	(38		)	(105		)	55			(200		)
Settlement of forward starting swaps on debt issuance (Note 8, 10)	—			—			(24		)	—
Other operating activities, net	(6		)	(1		)	(23		)	(88		)
Change in non-cash working capital balances related to operations	(72		)	(57		)	(66		)	(167		)
Cash provided by operating activities	673			527			1,781			1,449
Investing activities
Additions to properties	(430		)	(319		)	(1,084		)	(895		)
Proceeds from sale of properties and other assets	7			13			16			29
Other	—			—			(1		)	5
Cash used in investing activities	(423		)	(306		)	(1,069		)	(861		)
Financing activities
Dividends paid	(92		)	(83		)	(255		)	(229		)
Issuance of CP Common Shares	4			2			16			39
Purchase of CP Common Shares (Note 9)	—			(226		)	(559		)	(368		)
Issuance of long-term debt, excluding commercial paper (Note 8)	—			—			638			—
Repayment of long-term debt, excluding commercial paper (Note 8)	(5		)	(3		)	(744		)	(17		)
Net repayment of commercial paper (Note 8)	(53		)	—			—			—
Settlement of forward starting swaps on de-designation	—			—			—			(22		)
Cash used in financing activities	(146		)	(310		)	(904		)	(597		)
Effect of foreign currency fluctuations on U.S. dollar-denominated cash and cash equivalents	(5		)	(7		)	4			(13		)
Cash position
Increase (decrease) in cash and cash equivalents	99			(96		)	(188		)	(22		)
Cash and cash equivalents at beginning of period	51			238			338			164
Cash and cash equivalents at end of period	$	150		$	142		$	150		$	142

Supplemental disclosures of cash flow information:
Income taxes paid	$	74		$	78		$	230		$	364
Interest paid	$	147		$	140		$	380		$	385

See Notes to Interim Consolidated Financial Statements.

INTERIM CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(unaudited)



(in millions of Canadian dollars except per share data)	Common shares (in millions)		Share capital			Additional paid-in capital			Accumulated other comprehensive loss			Retained earnings			Total shareholders’ equity
Balance at January 1, 2018	144.9		$	2,032		$	43		$	(1,741	)	$	6,103		$	6,437
Net income	—		—			—			—			1,406			1,406
Other comprehensive income (Note 4)	—		—			—			87			—			87
Dividends declared	—		—			—			—			(267		)	(267		)
Effect of stock-based compensation expense	—		—			8			—			—			8
CP Common Shares repurchased (Note 9)	(2.5	)	(35		)	—			—			(524		)	(559		)
Shares issued under stock option plan	0.2		20			(4		)	—			—			16
Balance at September 30, 2018	142.6		$	2,017		$	47		$	(1,654	)	$	6,718		$	7,128
Balance at January 1, 2017	146.3		$	2,002		$	52		$	(1,799	)	$	4,371		$	4,626
Net income	—		—			—			—			1,421			1,421
Other comprehensive income (Note 4)	—		—			—			84			—			84
Dividends declared	—		—			—			—			(237		)	(237		)
CP Common Shares repurchased (Note 9)	(1.8	)	(26		)	—			—			(342		)	(368		)
Shares issued under stock option plan	0.5		49			(10		)	—			—			39
Balance at September 30, 2017	145.0		$	2,025		$	42		$	(1,715	)	$	5,213		$	5,565

See Notes to Interim Consolidated Financial Statements.

NOTES TO INTERIM CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2018

(unaudited)

1 Basis of presentation

These unaudited interim consolidated financial statements of Canadian Pacific Railway Limited (“CP”, or “the Company”), expressed in Canadian dollars, reflect management’s estimates and assumptions that are necessary for their fair presentation in conformity with generally accepted accounting principles 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 2017 annual consolidated financial statements and notes included in CP's 2017 Annual Report on Form 10-K. The accounting policies used are consistent with the accounting policies used in preparing the 2017 annual consolidated financial statements, except for the newly adopted accounting policies discussed in Note 2.

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 of normal and 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

Implemented in 2018

Revenue from Contracts with Customers

On January 1, 2018, the Company adopted the new Accounting Standards Update ("ASU") 2014-09, issued by the Financial Accounting Standards Board ("FASB"), and all related amendments under FASB Accounting Standards Codification ("ASC") Topic 606, Revenue from Contracts with Customers, using the modified retrospective method. Comparative financial information has not been restated and continues to be reported under the accounting standards in effect for those periods. The Company did not recognize any adjustment to the opening balance of retained earnings upon adoption of ASC Topic 606. The Company expects the impact of adoption of this new standard to be immaterial to the Company’s net income on an ongoing basis.

Compensation - Retirement Benefits

On January 1, 2018, the Company adopted the changes required under ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Post-retirement Benefit Cost under FASB ASC Topic 715, Retirement Benefits as issued by the FASB in March 2017. In accordance with the ASU, beginning on January 1, 2018, the Company reports the current service cost component of net periodic benefit cost in Compensation and benefits on the Company’s Consolidated Statements of Income, and reports the Other components of net periodic benefit recovery as a separate item outside of Operating income on the Company’s Consolidated Statements of Income. The Company has applied these changes in presentation retrospectively, which resulted in a decrease in Operating income of $68 million and $203 million for the three and nine months ended September 30, 2017, respectively.

These changes in presentation do not result in any changes to net income or earnings per share. Details of the components of net periodic benefit costs are provided in Note 12 Pensions and other benefits.

The ASU also prospectively restricts capitalization of net periodic benefit costs to the current service cost component when applicable. This restriction has no impact on the Company’s operating income or amounts capitalized because the Company has and continues to only capitalize an appropriate portion of current service cost for self-constructed properties.

Derivatives and Hedging

In August 2017, the FASB issued ASU 2017-12, Targeted Improvements to Accounting for Hedging Activities, under FASB ASC Topic 815, Derivatives and Hedging. This improves the financial reporting of hedging relationships to better portray the economic results of an entity's risk management activities in its financial statements. These amendments also make targeted improvements to simplify the application of the hedge accounting guidance in GAAP. The amendments require the entire change in the fair value of the hedging instrument to be recorded in Other comprehensive income for effective cash flow hedges. Consequently, any ineffective portion of the change in fair value will no longer be recorded to the Consolidated Statement of Income as it arises. While the amendments are effective for public entities beginning on January 1, 2019, early adoption is permitted and the Company early adopted this ASU effective January 1, 2018. Entities are required to apply the amendments in this update to hedging relationships existing on the date of adoption, reflected as a cumulative-effect adjustment as of the beginning of the fiscal year of adoption. Other amendments to presentation and disclosure are applied prospectively. No significant cumulative-effect adjustment was required.

Accumulated Other Comprehensive Income - Reclassification

In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income under FASB ASC Topic 220, Income Statement - Reporting Comprehensive Income. The current standard ASC Topic 740, Income Taxes, requires deferred tax liabilities and assets to be adjusted for the effect of a change in tax laws or rates with the effect included in income from continuing operations in the reporting period that includes the enactment date. This includes the tax effects of items in Accumulated other comprehensive income ("AOCI") that were originally recognized in Other comprehensive income, subsequently creating stranded tax effects. This ASU allows a reclassification from AOCI to Retained earnings for stranded tax effects specifically resulting from the U.S. federal government's recently enacted tax bill, the Tax Cuts and Jobs Act. The amendments are effective for public entities beginning on January 1, 2019 and early adoption is permitted. Entities are required to apply these amendments either in the period of adoption or retrospectively to each period in which the effect of the change in tax rate from the Tax Cuts and Jobs Act was recognized. The Company early adopted this ASU effective January 1, 2018, electing not to change AOCI, Retained earnings or disclosure in the Company's Interim Consolidated Financial Statements.

Future changes

Leases

In February 2016, the FASB issued ASU 2016-02, Leases under FASB ASC Topic 842, Leases which will supersede the lease recognition and measurement requirements in Topic 840, Leases. This new standard requires recognition of right-of-use assets and lease liabilities by lessees for those leases classified as finance and operating leases with a maximum term exceeding 12 months. For CP this new standard will be effective for interim and annual periods commencing January 1, 2019. CP plans to adopt the new standard with a cumulative-effect adjustment to the opening balance of retained earnings at that date and no restatement of comparative periods’ financial information, as recently allowed by the FASB. The Company has a detailed plan to implement the new standard and, through a cross-functional team, is assessing contractual arrangements that may qualify as leases under the new standard. CP is also working with a vendor to implement a lease management system which will assist in delivering the required accounting changes. Testing and optimization of the lease management system is nearing completion. The Company is also finalizing procedures to validate the completeness of its inventory of arrangements that meet the new definition of operating lease, in parallel to documenting internal policy decisions and permitted elections. The impact of the new standard will be a material increase to right-of-use operating lease assets and operating lease liabilities on the consolidated balance sheet, primarily, as a result of operating leases currently not recognized on the balance sheet. The Company is currently evaluating disclosure requirements, including any prospective change to presentation within its Consolidated Statements of Income.

3 Revenues

Revenue is recognized when obligations under the terms of a contract with a customer are satisfied. Revenue is measured as the amount of consideration the Company expects to receive in exchange for providing services. Government-imposed taxes that the Company collects concurrent with revenue-generating activities are excluded from revenue. In the normal course of business the Company does not generate any material revenue through acting as an agent for other entities.

The following is a description of primary activities from which the Company generates revenue.

Freight revenues

The Company provides rail freight transportation services to a wide variety of customers and transports bulk commodities, merchandise freight and intermodal traffic. The Company signs service agreements with customers that dictate future services the Company is to perform for a customer at the time a bill of lading or service request is received. Each bill of lading or service request represents a separate and distinct performance obligation that the Company is obligated to satisfy. The transaction price is generally in the form of a fixed fee determined at the inception of the bill of lading or service request. The Company allocates the transaction price to each distinct performance obligation based on the estimated standalone selling price for each performance obligation. As each bill of lading or service request represents a separate and distinct performance obligation, the estimated standalone selling price is assessed at an observable price which is fair market value. Certain customer agreements include variable consideration in the form of rebates, discounts, or incentives. The expected value method is used to estimate variable consideration and is allocated to the applicable performance obligation and is recognized when the related performance obligation is satisfied. Additionally, the Company offers published rates for services through public tariffs in which a customer can request service, triggering a performance obligation of the Company. In accordance with ASC Topic 606, railway freight revenues continue to be recognized over time as services are provided based on the percentage of completed service method. Volume rebates to customers are accrued as a reduction of freight revenues based on estimated volumes and contract terms as freight service is provided. Freight revenues also include certain ancillary and other services provided in association with the performance of rail freight movements. Revenues from these activities are not material and therefore have been aggregated with the freight revenues from customer contracts with which they are associated.

Non-freight revenues

In accordance with ASC Topic 606, non-freight revenues, including passenger revenues, switching fees, and revenues from logistic services, continue to be recognized at the point in time the services are provided or when the performance obligations are satisfied. Non-freight revenues also include leasing revenues.

Disaggregation of revenue

The following table disaggregates the Company’s revenues from contracts with customers by major source:



	For the three months ended September 30				For the nine months ended September 30
(in millions of Canadian dollars)	2018		2017⁽¹⁾		2018		2017⁽¹⁾
Freight
Grain	$	384	$	351	$	1,113	$	1,107
Coal	171		165		486		478
Potash	130		103		358		310
Fertilizers and sulphur	55		52		171		181
Forest products	76		67		211		202
Energy, chemicals and plastics	339		208		874		651
Metals, minerals, and consumer products	208		192		595		552
Automotive	85		68		247		223
Intermodal	406		341		1,133		1,004
Total freight revenues	1,854		1,547		5,188		4,708
Non-freight excluding leasing revenues	28		34		76		91
Revenues from contracts with customers	1,882		1,581		5,264		4,799
Leasing revenues	16		14		46		42
Total revenues	$	1,898	$	1,595	$	5,310	$	4,841

⁽¹⁾ Prior period amounts have not been adjusted under the modified retrospective method.

Satisfying performance obligations

Payment by customers is due upon satisfaction of performance obligations. Payment terms are such that amounts outstanding at the period end are expected to be collected within one reporting period. The Company invoices customers at the time the bill of lading or service request is processed and therefore the Company has no material unbilled receivables and no contract assets. All performance obligations not fully satisfied at period end are expected to be satisfied within the reporting period immediately following.

4 Changes in Accumulated other comprehensive loss ("AOCL") by component



	For the three months ended September 30
(in millions of Canadian dollars)	Foreign currency net of hedging activities⁽¹⁾			Derivatives and other⁽¹⁾			Pension and post- retirement defined benefit plans⁽¹⁾			Total⁽¹⁾
Opening balance, July 1, 2018	$	110		$	(64	)	$	(1,719	)	$	(1,673	)
Other comprehensive (loss) income before reclassifications	(1		)	(2		)	1			(2		)
Amounts reclassified from accumulated other comprehensive loss	—			2			19			21
Net other comprehensive (loss) income	(1		)	—			20			19
Closing balance, September 30, 2018	$	109		$	(64	)	$	(1,699	)	$	(1,654	)
Opening balance, July 1, 2017	$	124		$	(97	)	$	(1,767	)	$	(1,740	)
Other comprehensive loss before reclassifications	(5		)	—			—			(5		)
Amounts reclassified from accumulated other comprehensive loss	—			2			28			30
Net other comprehensive (loss) income	(5		)	2			28			25
Closing balance, September 30, 2017	$	119		$	(95	)	$	(1,739	)	$	(1,715	)

⁽¹⁾Amounts are presented net of tax.



	For the nine months ended September 30
(in millions of Canadian dollars)	Foreign currency net of hedging activities⁽¹⁾			Derivatives and other⁽¹⁾			Pension and post- retirement defined benefit plans⁽¹⁾			Total⁽¹⁾
Opening balance, January 1, 2018	$	109		$	(89	)	$	(1,761	)	$	(1,741	)
Other comprehensive income before reclassifications	—			19			—			19
Amounts reclassified from accumulated other comprehensive loss	—			6			62			68
Net other comprehensive income	—			25			62			87
Closing balance, September 30, 2018	$	109		$	(64	)	$	(1,699	)	$	(1,654	)
Opening balance, January 1, 2017	$	127		$	(104	)	$	(1,822	)	$	(1,799	)
Other comprehensive loss before reclassifications	(8		)	(7		)	—			(15		)
Amounts reclassified from accumulated other comprehensive loss	—			16			83			99
Net other comprehensive (loss) income	(8		)	9			83			84
Closing balance, September 30, 2017	$	119		$	(95	)	$	(1,739	)	$	(1,715	)

⁽¹⁾Amounts are presented net of tax.

Amounts in Pension and post-retirement defined benefit plans reclassified from AOCL are as follows:



	For the three months ended September 30						For the nine months ended September 30
(in millions of Canadian dollars)	2018			2017			2018			2017
Amortization of prior service costs⁽¹⁾	$	(1	)	$	(1	)	$	(2	)	$	(3	)
Recognition of net actuarial loss⁽¹⁾	29			39			88			116
Total before income tax	28			38			86			113
Income tax recovery	(9		)	(10		)	(24		)	(30		)
Total net of income tax	$	19		$	28		$	62		$	83

⁽¹⁾Impacts "Other components of net periodic benefit recovery" on the Interim Consolidated Statements of Income.

5 Other (income) expense



	For the three months ended September 30						For the nine months ended September 30
(in millions of Canadian dollars)	2018			2017			2018			2017
Foreign exchange (gain) loss on long-term debt	$	(38	)	$	(105	)	$	55		$	(200	)
Other foreign exchange (gains) losses	(1		)	(3		)	2			(5		)
Insurance recovery of legal settlement	—			—			—			(10		)
Charge on hedge roll and de-designation	—			—			—			13
Other	(8		)	3			(1		)	8
Other (income) expense	$	(47	)	$	(105	)	$	56		$	(194	)

"Other (income) expense" was previously presented as "Other income and charges" in the Company's Consolidated Statements of Income. This change in presentation has no impact on the components within this line item.

6 Income taxes



	For the three months ended September 30				For the nine months ended September 30
(in millions of Canadian dollars)	2018		2017		2018		2017
Current income tax expense	$	122	$	93	$	288	$	288
Deferred income tax expense	77		77		155		168
Income tax expense	$	199	$	170	$	443	$	456

During the nine months ended September 30, 2018, legislation was enacted to decrease the Iowa and Missouri state corporate income tax rates. As a result of these changes, the Company recorded a deferred tax recovery of $21 million in the second quarter of 2018 related to the revaluation of deferred income tax balances as at January 1, 2018.

The effective tax rates for the three and nine months ended September 30, 2018, were 24.23% and 23.95%, respectively, compared to 24.95% and 24.28% for the same periods in 2017.

For the three months ended September 30, 2018, the effective tax rate excluding the discrete item of the foreign exchange ("FX") gain of $38 million on the Company's U.S. dollar-denominated debt, was 24.75%.

For the three months ended September 30, 2017, the effective tax rate excluding the discrete items of the FX gain of $105 million on the Company's U.S. dollar-denominated debt, and the $3 million deferred tax expense related to legislation enacted to increase the Illinois state income tax rate, was 26.50%

For the nine months ended September 30, 2018, the effective tax rate excluding the discrete items of the FX loss of $55 million on the Company's U.S. dollar-denominated debt and the $21 million tax recovery described above, was 24.75%.

For the nine months ended September 30, 2017, the effective tax rate excluding the discrete items of the management transition recovery of $51 million related to the retirement of the Company's Chief Executive Officer, the FX gain of $200 million on the Company's U.S. dollar-denominated debt, an insurance recovery of $10 million on a legal settlement, the $13 million charge associated with the hedge roll and de-designation, and the $14 million tax net recovery related to legislation enacted to increase the Illinois tax rate and decrease the Saskatchewan provincial corporate income tax rate, was 26.50%.

7 Earnings per share

At September 30, 2018, the number of shares outstanding was 142.6 million (September 30, 2017 - 145.0 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 ended September 30		For the nine months ended September 30
(in millions)	2018	2017	2018	2017
Weighted-average basic shares outstanding	142.6	145.5	143.2	146.2
Dilutive effect of stock options	0.5	0.3	0.5	0.4
Weighted-average diluted shares outstanding	143.1	145.8	143.7	146.6

For the three and nine months ended September 30, 2018, there were 0.3 million and 0.2 million options, respectively, excluded from the computation of diluted earnings per share because their effects were not dilutive (three and nine months ended September 30, 2017 - 0.3 million and 0.3 million).

8 Debt

Revolving credit facility

Effective June 8, 2018, the Company amended its U.S. $2.0 billion revolving credit facility agreement dated September 26, 2014. This fifth amending agreement included, among other things, the extension of the five year maturity date from June 28, 2022 to June 28, 2023 and the cancellation of the U.S. $1.0 billion one-year plus one-year credit facility agreement. As at September 30, 2018, the remaining U.S. $1.0 billion credit facility was undrawn.

Issuance of long-term debt

During the second quarter of 2018, the Company issued U.S. $500 million 4.000% 10-year Notes due June 1, 2028 for net proceeds of U.S. $495 million ($638 million). These notes pay interest semi-annually and are unsecured but carry a negative pledge. In conjunction with the issuance, the Company settled a notional U.S. $500 million of forward starting floating-to-fixed interest rate swap agreements ("forward starting swaps") for a payment of U.S. $19 million ($24 million) (see Note 10). This payment was included in cash provided by operating activities consistent with the location of the related hedged item on the Company's Interim Consolidated Statements of Cash Flows.

Retirement of long-term debt

During the second quarter of 2018, the Company repaid U.S. $275 million 6.500% 10-year Notes at maturity for a total of U.S. $275 million ($352 million) and $375 million 6.250% 10-year Medium Term Notes at maturity for a total of $375 million.

Commercial paper program

The Company has a commercial paper program which enables it to issue commercial paper up to a maximum aggregate principal amount of U.S. $1.0 billion in the form of unsecured promissory notes. The commercial paper is backed by the U.S. $1.0 billion revolving credit facility. As at September 30, 2018 and December 31, 2017, the Company had no commercial paper borrowings.

The Company presents issuances and repayments of commercial paper, all of which have a maturity of less than 90 days, in the Company's Interim Consolidated Statements of Cash Flows on a net basis.

9 Shareholders' equity

On May 10, 2017, the Company announced a new normal course issuer bid ("NCIB"), commencing May 15, 2017, to purchase up to 4.38 million Common Shares for cancellation before May 14, 2018. The Company completed this NCIB on May 10, 2018.

All purchases were made in accordance with the NCIB at prevalent market prices plus brokerage fees, or such other prices that were permitted by the Toronto Stock Exchange, with consideration allocated to share capital up to the average carrying amount of the shares, and any excess allocated to retained earnings.

The following table describes activities under the share repurchase program:



	For the three months ended September 30				For the nine months ended September 30
	2018		2017		2018		2017
Number of Common Shares repurchased	—		1,145,400		2,495,962		1,828,300
Weighted-average price per share⁽¹⁾	$	—	$	196.46	$	223.97	$	201.50
Amount of repurchase (in millions)⁽¹⁾	$	—	$	225	$	559	$	368

⁽¹⁾Includes brokerage fees.

On October 17, 2018, the Company announced that it intends to implement a new NCIB to repurchase, for cancellation, up to approximately 5.68 million of its Common Shares, subject to Toronto Stock Exchange acceptance.

10 Financial instruments

A. Fair values of financial instruments

The Company categorizes its financial assets and liabilities measured at fair value into a three-level hierarchy established by GAAP that prioritizes those inputs to valuation techniques used to measure fair value based on the degree to which they are observable. The three levels of the fair value hierarchy are as follows: Level 1 inputs are quoted prices in active markets for identical assets and liabilities; Level 2 inputs, other than quoted prices included within Level 1, are observable for the asset or liability either directly or indirectly; and Level 3 inputs are not observable in the market.

When possible, the estimated fair value is based on quoted market prices and, if not available, it is based on 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, FX and commodity) and volatility, depending on the type of derivative and the 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. All derivatives and long-term debt are classified as Level 2.

The carrying values of financial instruments equal or approximate their fair values with the exception of long-term debt:

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 principal and interest at estimated interest rates expected to be available to the Company at period end.

B. Financial risk management

Derivative financial instruments

Derivative financial instruments may be used to selectively reduce volatility associated with fluctuations in interest rates, 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 Company's Interim Consolidated Balance Sheets, commitments or forecasted transactions. At the time a derivative contract is entered into and at least quarterly thereafter, an assessment is made as to 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.

FX management

The Company conducts business transactions and owns assets in both Canada and the United States. As a result, the Company is exposed to fluctuations in the value of financial commitments, assets, liabilities, income or cash flows due to changes in FX rates. The Company may enter into FX risk management transactions primarily to manage fluctuations in the exchange rate between Canadian and U.S. currencies. FX exposure is primarily mitigated through natural offsets created by revenues, expenditures and balance sheet positions incurred in the same currency. Where appropriate, the Company may negotiate with customers and suppliers to reduce the net exposure.

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 effect of the net investment hedge recognized in “Other comprehensive income” for the three and nine months ended September 30, 2018 was an unrealized FX gain of $96 million and an unrealized FX loss of $177 million, respectively (three and nine months ended September 30, 2017 - an unrealized FX gain of $180 million and $342 million, respectively).

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 ongoing 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, that are 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.

Forward starting swaps

During the second quarter of 2018, the Company settled a notional U.S. $500 million of forward starting swaps related to the U.S. $500 million 4.000% 10-year Notes issued in the same period. The fair value of these derivative instruments at the time of settlement was a loss of U.S. $19 million ($24 million). The changes in fair value of the forward starting swaps for the three and nine months ended September 30, 2018 was $nil and a gain of $31 million, respectively (three and nine months ended September 30, 2017 - $nil and a loss of $12 million, respectively). This was recorded in "Accumulated other comprehensive loss”, net of tax, and is being reclassified to "Net interest expense" until the underlying hedged notes are repaid.

For the three and nine months ended September 30, 2018, a net loss of $2 million and $7 million, respectively, related to settled forward starting swap hedges has been amortized to “Net interest expense” (three and nine months ended September 30, 2017 - a net loss of $3 million and $8 million, respectively). The Company expects that during the next twelve months, an additional $9 million of net losses will be amortized to “Net interest expense”.

11 Stock-based compensation

At September 30, 2018, the Company had several stock-based compensation plans, including stock option plans, various cash settled liability plans and an employee share purchase plan. These plans resulted in an expense for the three and nine months ended September 30, 2018 of $28 million and $60 million, respectively (three and nine months ended September 30, 2017 - an expense of $11 million and $16 million, respectively).

Effective January 31, 2017, Mr. E. Hunter Harrison resigned from all positions held by him at the Company, including as the Company’s Chief Executive Officer and a member of the Board of Directors of the Company. In connection with Mr. Harrison’s resignation, the Company entered into a separation agreement with Mr. Harrison. Under the terms of the separation agreement, the Company agreed to a limited waiver of Mr. Harrison’s non-competition and non-solicitation obligations.

Effective January 31, 2017, pursuant to the separation agreement, Mr. Harrison forfeited certain pension and post-retirement benefits and agreed to the surrender for cancellation of 22,514 performance share units ("PSUs"), 68,612 deferred share units ("DSUs"), and 752,145 stock options.

As a result of this agreement, the Company recognized a recovery of $51 million in "Compensation and benefits" in the first quarter of 2017. Of this amount, $27 million related to a recovery from cancellation of certain pension benefits.

Stock option plan

In the nine months ended September 30, 2018, under CP’s stock option plans, the Company issued 282,125 options at the weighted-average price of $240.91 per share, based on the closing price on the grant date.

Pursuant to the employee plan, these options may be exercised upon vesting, which is between 12 months and 48 months after the grant date, and will expire after seven years.

Under the fair value method, the fair value of the stock options at the grant date was approximately $16 million. The weighted-average fair value assumptions were approximately:



	For the nine months ended September 30, 2018
Grant price	$240.91
Expected option life (years)⁽¹⁾	5.00
Risk-free interest rate⁽²⁾	2.22%
Expected stock price volatility⁽³⁾	24.81%
Expected annual dividends per share⁽⁴⁾	$2.3854
Expected forfeiture rate⁽⁵⁾	4.7%
Weighted-average grant date fair value per option granted during the period	$55.63


⁽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 term commensurate with the expected term of the option.


⁽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. On May 10, 2018, the Company announced an increase in its quarterly dividend to $0.6500 per share, representing $2.6000 on an annual basis.


⁽⁵⁾	The Company estimated forfeitures based on past experience. This rate is monitored on a periodic basis.

Performance share unit plan

In the nine months ended September 30, 2018, the Company issued 161,323 PSUs with a grant date fair value of approximately $39 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 or in CP Common Shares, approximately three years after the grant date, contingent upon CP’s performance ("performance factor").

The performance period for the PSUs issued in the nine months ended September 30, 2018 is January 1, 2018 to December 31, 2020. The fair value of these PSUs is measured periodically until settlement, using either a lattice-based valuation model or a Monte Carlo simulation model.

The performance period for the PSUs issued in 2015 was January 1, 2015 to December 31, 2017. The performance factors for these PSUs were Operating Ratio, ROIC, TSR compared to the S&P/TSX 60 index and TSR compared to Class I railways. The resulting payout was 160% of the Company's average share price that was calculated using the last 30 trading days preceding December 31, 2017. In the first quarter of 2018, payouts occurred on the total outstanding awards, including dividends reinvested, totaling $30 million on 82,800 outstanding awards.

Deferred share unit plan

In the nine months ended September 30, 2018, the Company granted 13,888 DSUs with a grant date fair value of approximately $3 million. DSUs vest over various periods of up to 48 months and are only redeemable for a specified period after employment is terminated. An expense to income for DSUs is recognized over the vesting period for both the initial subscription price and the change in value between reporting periods.

Restricted share unit plan

In the nine months ended September 30, 2018, the Company granted 21,895 restricted share units ("RSUs") with a grant date fair value of approximately $5 million. The RSUs are notional full value shares that attract dividend equivalents in the form of additional units based on the dividends paid on the Company’s Common Shares. RSUs have no performance factors attached to them and are vested and settled in cash after a period of three years from the grant date. An expense to income for RSUs is recognized over the vesting period for both the initial subscription price and the change in value between reporting periods.

12 Pension and other benefits

In the three months ended September 30, 2018, the Company made contributions of $13 million (three months ended September 30, 2017 - $11 million) to its defined benefit pension plans. In the nine months ended September 30, 2018, the Company made net contributions of $25 million (nine months ended September 30, 2017 - $35 million), to its defined benefit pension plans, which is net of a $10 million refund of plan surplus (nine months ended September 30, 2017 - $nil). Net periodic benefit costs for defined benefit pension plans and other benefits recognized in the three and nine months ended September 30, 2018 included the following components:



	For the three months ended September 30
	Pensions						Other benefits
(in millions of Canadian dollars)	2018			2017			2018		2017
Current service cost (benefits earned by employees)	$	30		$	26		$	3	$	3
Other components of net periodic benefit (recovery) cost:
Interest cost on benefit obligation	110			112			5		5
Expected return on fund assets	(239		)	(223		)	—		—
Recognized net actuarial loss	29			38			—		1
Amortization of prior service costs	(1		)	(1		)	—		—
Total other components of net periodic benefit (recovery) cost	(101		)	(74		)	5		6
Net periodic benefit (recovery) cost	$	(71	)	$	(48	)	$	8	$	9



	For the nine months ended September 30
	Pensions						Other benefits
(in millions of Canadian dollars)	2018			2017			2018		2017
Current service cost (benefits earned by employees)	$	90		$	77		$	9	$	9
Other components of net periodic benefit (recovery) cost:
Interest cost on benefit obligation	329			338			14		15
Expected return on fund assets	(716		)	(669		)	—		—
Recognized net actuarial loss	86			114			2		2
Amortization of prior service costs	(2		)	(3		)	—		—
Total other components of net periodic benefit (recovery) cost	(303		)	(220		)