Canadian National Railway Company Annual Report 2011

Plain-text annual report

OPERATIONAL AND SERVICE EXCELLENCE 2 0 1 1 a n n u a l r e p o r t 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 www.cn.ca 2 0 1 1 a n n u a l r e p o r t Contents 1 A message from the Chairman 2 A message from Claude Mongeau 4 Operational and Service Excellence 6 Board of Directors 7 Financial Section (U.S. GAAP) 87 Corporate Governance – Delivering Responsibly 88 Shareholder and Investor Information Except where otherwise indicated, all ﬁ nancial information reﬂ ected in this document is expressed in Canadian dollars and determined on the basis of United States gener- ally accepted accounting principles (U.S. GAAP). Certain information included in this annual report constitutes “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995 and under Canadian securities laws. CN cautions that, by their nature, these forward-looking statements involve risks, uncertainties and assumptions. The Company cautions that its assumptions may not materialize and that current economic conditions render such assumptions, although reasonable at the time they were made, subject to greater uncertainty. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company or the rail industry to be materially different from the outlook or any future results or performance implied by such statements. Important risk factors that could affect the forward-looking statements include, but are not limited to, the effects of general economic and business conditions, industry competition, inﬂ ation, currency and interest rate ﬂ uctuations, changes in fuel prices, legislative and/or regulatory developments, compliance with environmental laws and regulations, actions by regulators, various events which could disrupt operations, including natural events such as severe weather, droughts, ﬂ oods and earthquakes, labor negotiations and disruptions, environmental claims, uncertainties of investigations, proceedings or other types of claims and litigation, risks and liabilities arising from derailments, and other risks detailed from time to time in reports ﬁ led by CN with securities regulators in Canada and the United States. Reference should be made to “Manage- ment’s Discussion and Analysis” in CN’s annual and interim reports, Annual Information Form and Form 40-F ﬁ led with Canadian and U.S. securities regulators, available on CN’s website (www.cn.ca), for a summary of major risks. CN assumes no obligation to update or revise forward-looking statements to reﬂ ect future events, changes in circum- stances, or changes in beliefs, unless required by applicable Canadian securities laws. In the event CN does update any forward-looking statement, no inference should be made that CN will make additional updates with respect to that state- ment, related matters, or any other forward-looking statement. As used herein, the word “Company” or “CN” means, as the context requires, Canadian National Railway Company and/ or its subsidiaries. This report has been printed on FSC® paper. A message from the Chairman Dear fellow shareholders 2011 was a year full of excellent progress on CN’s corporate agenda to deliver solid shareholder value through operational and service excellence. The Board was very pleased with the performance of the Leadership Team led by our CEO, Claude Mongeau. They have worked diligently to improve the relationship with stakeholders and customers. We are proud of the progress CN had made on many fronts. Our employees are motivated to ensure the railroad continues to run efficiently and safely. The CN Leadership Team has a clear vision of what it takes to create value for customers and shareholders, and it’s equally clear that the team of CN’s 23,000 rail roaders buy into it. CN’s role as a transportation backbone of the economy makes it indispensible to many of the most important industries in North America, transporting goods throughout the continent in the most environmentally responsible manner. CN’s sustainability practices have earned it a place on the Dow Jones Sustainability Index (DJSI) North America for a third straight year, the only railroad to have achieved this distinction. “ CN’s role as a transportation backbone of the economy makes it indispensible to many of the most important industries in North America...” A critical factor for maintaining CN’s leadership position in the market place is the renewal of its workforce; the Company hired nearly 3,000 new employees in 2011 to address the combination of attrition and our growing business. The Board also understands the need to renew its own membership, and we were delighted to add two highly skilled and experienced leaders to our ranks in 2011 – Donald J. Carty, former Chairman and CEO of American Airlines and former ViceChairman and Chief Financial Officer of Dell, Inc., as well as James E. O’Connor, former Chairman and CEO of Republic Services, Inc. The foundation for our success is a talented management team and a wellmotivated workforce. We are confident that CN is well positioned to continue the spirit of excellence we have developed and to deliver increasing customer satisfaction and share holder value well into the future. Sincerely, David McLean, O.B.C., LL.D. Chairman of the Board Canadian National Railway Company 2011 Annual Report 1 A message from Claude Mongeau OPERATIONAL AND SERVICE EXCELLENCE Dear fellow shareholders CN’s exceptional financial results for 2011 demonstrate our ability to consistently deliver value to customers and shareholders. Our broadbased service innovation benefited our customers and allowed us to grow the business faster than the overall economy, which translated into record annual carloadings, revenues and earnings. Our focus on Operational and Service Excellence is unwavering and is at the root of our success in 2011 and our plans for the future. For many years, CN’s relentless pursuit of efficiency has been the Company’s hallmark. Our Precision Railroading model, which focuses on improving every process that affects delivery of the customers’ goods, continues to guide the Company’s performance. In 2011, we strengthened our commitment to Operational and Service Excellence through a wide range of innovations anchored on our continuous improvement philosophy. Greater value for the customers Ultimately, we are in business to help customers win in their own markets. While CN is a leader in fast and reliable service hub to hub, we are truly distinguishing ourselves by bringing greater value to the entire range of customer touch points. Our first mile/ last mile efforts are all about quality interaction with our customers, from developing a sharper outsidein perspective to better monitoring of traffic forecasts; from moving our car management distribution activities forward to higher and more responsive car order fulfillment. Our successful Scheduled Grain Service is reflected in much improved car spotting reliability and is a good example of the way CN is driving fundamental “ ...CN’s relentless pursuit of effi- ciency has been the Company’s hallmark.” innovation in the industry. Our relentless focus on execution supports all of our activities. Our investments in capacity contribute to enhancing the fluidity of our network. We work hard to run more efficient trains, reduce dwell time at our terminals, and improve overall network velocity. The reconfiguration of our yards and terminals, including the significant expansion of Kirk Yard in Gary, Indiana, which is currently underway, is another key example of such focus. Our Fuel Management Excellence program – which deploys stateoftheart technology and better trainhandling – results in significant 2 2011 Annual Report Canadian National Railway Company productivity gains and helps reduce greenhouse gas emissions. And because safety enables performance, embedding a safety culture in all aspects of our operations remains a top priority. Improving the efficiency of the entire supply chain The greatest opportunity to take railroading to the next level is to improve the efficiency of the entire supply chain. We set our sights on becoming a true supply chain enabler, a player that “ We set our sights on be- coming a true supply chain enabler...” can be a key part of the solution, a railroad that can help elevate logistics performance end to end. We have an ability – and are well positioned – to use collaboration as a driver of accountability. We are at the forefront of groundbreaking supply chain and service level agreements throughout our North American network. Such agreements are not based on templates or a onesizefitsall approach. Each is unique and custommade to reflect mutually agreed upon goals in a complex network business, including, for example, car supply, dwell time, loading requirements, and more. Customers are starting to see significant value in this collaborative framework and the positive results will continue to gain momentum. We are driving supply chain improvements across all segments of the business. In Bulk, be it in grain, potash or coal, we are pursuing greater operating efficiencies and helping our customers find their place in global markets. In Manufacturing, be it in forest products, metals or petroleum and chemicals, we are focused on better car order fulfillment to gain market share one carload at a time. In Intermodal, we are taking advantage of supply chain agreements with every major port and terminal operator in Canada to open up new gateway markets. Of course, all the agreements, strategies and commitments in the world are worth very little if you don’t have the team that can pull it off. Fortunately, CN has what I consider to be the finest team of railroaders in the business. Our employees bring the plan to life and make it all happen through our shared passion, pride and teamwork. At the end of the day, this is what gives me the confidence that CN will continue to bring solid value to shareholders and customers in 2012 and beyond. Claude Mongeau President and CEO Canadian National Railway Company 2011 Annual Report 3 HELPING OUR CUSTOMERS GROW OPERATIONAL AND SERVICE ExCELLENCE: Helping coal customers serve Innovating for Intermodal global markets CN’s domestic, crossborder and In 2011, CN moved more than overseas Intermodal clients are 20 million tons of coal and petro benefiting from an overall improved leum coke destined for offshore customer experience in the move markets. As capacity limits in West ment of their goods and interaction Coast coal export terminals were with the com pany. Thanks to supply constraining coal producers, we chain colla boration, service level at CN took action rather than just agree ments and tailored scorecards, waiting for capacity to expand. Fairview Container Terminal at the Building on our innovative endto CNserved Port of Prince Rupert is end supply chain agreements, we on a solid growth path. Operational developed an exclusive information and Service Excellence results in system to better manage the flow faster transit times to key markets of coal “from the mine to the ship.” and distribution hubs, such as The system is shared by CN and Memphis and Chicago, as well each customer individually, so that as more efficient terminals and we’re working from the same tool, handling of containers. Examples which is unique in the rail industry. of customerfocused improvements Working with the customers and the in 2011 include CN’s busiest coal terminal operators, we made Intermodal Terminal in Brampton, the most of the supply chain by Ontario, where new track increased modifying scheduling for ships and rail capacity by close to 15 per trains, and making other changes cent. Other Brampton initiatives to improve productivity and fluidity. include 25 per cent more ground As a result, CN moved more than space for international containers, a million tons of additional coal in new cranes, and new entry and exit 2011 that may never have made it lanes for truckers that improved gate to market, a substantial contribution throughput by 33 per cent. Adding to help our customers grow their to CN’s environmental advantage of business. being the most fuel efficient railroad was the addition of EcoTherm Inter modal containers that retain the proper temperature for sensitive goods without using fuel while 4 2011 Annual Report Canadian National Railway Company on rail and EcoRide chassis, which help improve the supply chain for consume up to 11 per cent less exporting grain to world markets fuel than containers delivered on while tightly managing costs and traditional chassis. network balance. Gains for Grain Measuring up for Manufacturing CN’s Scheduled Grain Service, CN believes that if something must introduced in 2010, contributed to be managed, it must be measured. the Company’s success in moving Improvements in car order fulfilment more than 125,000 grain cars to in 2011 represent an eloquent export terminals in Vancouver and example of Service Excellence, but Prince Rupert during the 2010 that only tells part of the story. The 2011 crop year ended on July 31 – range of reports to track car ordering the most in 20 years. During the performance was expanded and fall of 2011, when the crop was refined, and the bar was raised in really starting to move, CN handled what is being measured. Our targets record weekly volumes of grain are now more closely aligned with and achieved high levels of car an outsidein perspective, so that spotting reliability. Under what is shared metrics give all the players a a much more disciplined approach more accurate view of performance to grain service, fully 95 per cent on a daytoday basis. CN is also of grain traffic is now scheduled. extending its car management Having a preestablished day of the expertise to private cars in order to week for service allows customers reduce dwell and improve car cycles to plan more accurately for their for customers owning their fleet. own business activities. It facilitates This includes shared accountability communications. Transit times, on fleet optimization, with the cycles and reliability have improved customer sharing loading plans with as well, increasing emptycar CN. A pipeline model drives the flow and fleet capacity for grain configuration of empty movements, customers. The plan allows CN to with CN facilitating surplus fleet smooth the network traffic over decisions and contributing to the seven days instead of the five creation of value for the customers. day period used in the past. CN’s new grain plan is intended to Canadian National Railway Company 2011 Annual Report 5 Board of Directors As at February 15, 2012 David G.A. McLean, O.B.C., LL.D. Chairman of the Board Canadian National Railway Company Chairman of the Board The McLean Group Committees: 2, 3*, 4, 6, 7, 8 Donald J. Carty, O.C., LL.D. Retired Chairman and CEO American Airlines and Retired ViceChairman Dell, Inc. Committees: 1, 2, 3, 7 Claude Mongeau President and Chief Executive Officer Canadian National Railway Company Committees: 4*, 7 Michael R. Armellino, CFA Retired Partner The Goldman Sachs Group, LP Committees: 2, 5, 6, 7*, 8 A. Charles Baillie, O.C., LL.D. Former Chairman and Chief Executive Officer The TorontoDominion Bank Committees: 2*, 3, 6, 7, 8 Hugh J. Bolton, FCA Chairman of the Board EPCOR Utilities Inc. Committees: 1, 5, 6, 7, 8 Ambassador Gordon D. Giffin Senior Partner McKenna Long & Aldridge Committees: 2, 4, 5, 7, 8 Edith E. Holiday Corporate Director and Trustee Former General Counsel United States Treasury Department Secretary of the Cabinet The White House Committees: 2, 3, 6, 7, 8 V. Maureen Kempston Darkes, O.C., D.Comm., LL.D. Retired Group VicePresident General Motors Corporation and President GM Latin America, Africa and Middle East Committees: 1, 5*, 6, 7, 8 The Honourable Denis Losier, C.M., P.C., LL.D. President and Chief Executive Officer Assumption Life Committees: 1*, 4, 5, 6, 7 The Honourable Edward C. Lumley, P.C., LL.D. ViceChairman BMO Capital Markets Committees: 2, 3, 6, 7, 8* James E. O’Connor Former Chairman and Chief Executive Officer Republic Services Inc. Committees: 1, 2, 5, 7 Robert Pace President and Chief Executive Officer The Pace Group Committees: 1, 3, 6*, 7, 8 Directors Emeritus Purdy Crawford J.V. Raymond Cyr James K. Gray Cedric Ritchie Committees: 1 Audit 2 Finance 3 Corporate governance and nominating 4 Donations and sponsorships 5 Environment, safety and security 6 Human resources and compensation 7 Strategic planning 8 Investment * denotes chairman of the committee Chairman of the Board and Select Senior Officers of the Company As at February 15, 2012 David G.A. Mc Lean Chairman of the Board Claude Mongeau President and Chief Executive Officer Keith Creel Executive VicePresident and Chief Operating Officer Mike Cory Senior VicePresident Western Region Sean Finn Executive VicePresident Corporate Services and Chief Legal Officer Sameh Fahmy Senior VicePresident Engineering, Mechanical and Supply Management Luc Jobin Executive VicePresident and Chief Financial Officer Jeff Liepelt Senior VicePresident Eastern Region Jean-Jacques Ruest Executive VicePresident and Chief Marketing Officer Jim Vena Senior VicePresident Southern Region Kimberly A. Madigan VicePresident Human Resources Robert E. Noorigian VicePresident Investor Relations Russell Hiscock President and Chief Executive Officer CN Investment Division 6 2011 Annual Report Canadian National Railway Company Financial Section (U.S. GAAP) Contents 8 Selected Railroad Statistics 9 Management’s Discussion and Analysis 49 Management’s Report on Internal Control over Financial Reporting 49 Report of Independent Registered Public Accounting Firm 50 Report of Independent Registered Public Accounting Firm 51 Consolidated Statement of Income 52 Consolidated Statement of Comprehensive Income 53 Consolidated Balance Sheet 54 Consolidated Statement of Changes in Shareholders’ Equity 55 Consolidated Statement of Cash Flows Notes to Consolidated Financial Statements 56 1 Summary of significant accounting policies 58 2 Accounting changes 59 3 Acquisition 59 4 Accounts receivable 60 5 Properties 62 6 Intangible and other assets 62 7 Accounts payable and other 62 8 Other liabilities and deferred credits 63 9 Long-term debt 65 10 Capital stock 65 11 Stock plans 70 12 Pensions and other postretirement benefits 76 13 Other income 77 14 Income taxes 78 15 Segmented information 79 16 Earnings per share 80 17 Major commitments and contingencies 84 18 Financial instruments 86 19 Accumulated other comprehensive loss 86 20 Comparative figures Canadian National Railway Company 2011 Annual Report 7 Selected Railroad Statistics (1) Year ended December 31, Statistical operating data Rail freight revenues ($ millions) Gross ton miles (GTM) (millions) Revenue ton miles (RTM) (millions) Carloads (thousands) Route miles (includes Canada and the U.S.) (2) Employees (end of year) Employees (average for the year) Productivity Operating ratio (%) Rail freight revenue per RTM (cents) Rail freight revenue per carload ($) Operating expenses per GTM (cents) Labor and fringe benefits expense per GTM (cents) GTMs per average number of employees (thousands) Diesel fuel consumed (US gallons in millions) Average fuel price ($/US gallon) GTMs per US gallon of fuel consumed Safety indicators Injury frequency rate per 200,000 person hours (3) Accident rate per million train miles (3) (1) Includes data relating to companies acquired as of the date of acquisition. (2) Rounded to the nearest hundred miles. (3) Based on Federal Railroad Administration (FRA) reporting criteria. 2011 2010 2009 8,111 7,417 6,632 357,927 341,219 304,690 187,753 179,232 159,862 4,873 4,696 3,991 20,000 20,600 21,100 23,230 22,279 21,501 22,985 21,967 21,793 63.5 4.32 63.6 4.14 67.3 4.15 1,664 1,579 1,662 1.60 0.51 1.55 0.51 1.63 0.56 15,572 15,533 13,981 367.7 355.7 327.3 3.39 973 1.55 2.25 2.64 959 1.72 2.23 2.28 931 1.78 2.27 Certain of the 2010 and 2009 comparative figures have been restated to conform with the 2011 presentation. Such statistical data and related productivity measures are based on estimated data available at such time and are subject to change as more complete information becomes available. 8 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Management’s discussion and analysis (MD&A) relates to the financial position and results of operations of Canadian National Railway Company, together with its wholly-owned subsidiaries, collectively “CN” or “the Company.” Canadian National Railway Company’s common shares are listed on the Toronto and New York stock exchanges. Except where otherwise indicated, all financial information reflected herein is expressed in Canadian dollars and determined on the basis of United States generally accepted accounting principles (U.S. GAAP). The Company’s objec- tive is to provide meaningful and relevant information reflecting the Company’s financial position and results of operations. In certain instances, the Company may make reference to certain non-GAAP measures that, from management’s perspective, are useful measures of performance. The reader is advised to read all information provided in the MD&A in conjunction with the Company’s 2011 Annual Consolidated Financial Statements and Notes thereto. Business profile Strategy overview CN is engaged in the rail and related transportation business. CN’s focus is on running a safe and efficient railroad. While CN’s network of approximately 20,000 route miles of track spans remaining at the forefront of the rail industry, CN’s goal is to be Canada and mid-America, connecting three coasts: the Atlantic, internationally regarded as one of the best-performing transpor- the Pacific and the Gulf of Mexico. CN’s extensive network, and tation companies. its co-production arrangements, routing protocols, marketing alli- CN’s commitment is to create value for both its customers and ances, and interline agreements, provide CN customers access to shareholders. By staying engaged with customers and leveraging all three North American Free Trade Agreement (NAFTA) nations. the strength of its franchise, the Company seeks to provide qual- CN’s freight revenues are derived from seven commod- ity and cost-effective service that creates value for its customers. ity groups representing a diversified and balanced portfolio of CN’s corporate goals are generally based on five key financial goods transported between a wide range of origins and desti- performance targets: revenues, operating income, earnings per nations. This product and geographic diversity better positions share, free cash flow and return on invested capital, as well as the Company to face economic fluctuations and enhances its various key operating metrics, including safety metrics, that the potential for growth opportunities. In 2011, no individual com- Company focuses on to measure efficiency and quality of service. modity group accounted for more than 20% of revenues. From a By striving for sustainable financial performance through prof- geographic standpoint, 18% of revenues relate to United States itable growth, adequate free cash flow and return on invested (U.S.) domestic traffic, 28% transborder traffic, 22% Canadian capital, CN seeks to deliver increased shareholder value. In 2011, domestic traffic and 32% overseas traffic. The Company is the the Company’s Board of Directors approved two share repur- originating carrier for approximately 85% of traffic moving along chase programs funded mainly from cash generated from opera- its network, which allows it both to capitalize on service advan- tions. The first share repurchase program, which was approved tages and build on opportunities to efficiently use assets. in January 2011 was completed by September 30, 2011 and al- Corporate organization lowed for the repurchase of up to 16.5 million common shares to the end of December 2011. On October 25, 2011, the Board The Company manages its rail operations in Canada and the of Directors of the Company approved a second share repurchase United States as one business segment. Financial information program which allows for the repurchase of up to 17.0 million reported at this level, such as revenues, operating income and common shares between October 28, 2011 and October 27, cash flow from operations, is used by the Company’s corporate 2012. Share repurchases are made pursuant to a normal course management in evaluating financial and operational performance issuer bid at prevailing market prices, plus brokerage fees, or such and allocating resources across CN’s network. The Company’s other prices as may be permitted by the Toronto Stock Exchange. strategic initiatives, which drive its operational direction, are de- In addition, the Company’s Board of Directors approved an in- veloped and managed centrally by corporate management and crease of 15% to the quarterly dividend to common shareholders, are communicated to its regional activity centers (the Western from $0.325 in 2011 to $0.375 in 2012. Region, Eastern Region and Southern Region), whose role is to CN’s business model is anchored on five core principles: pro- manage the day-to-day service requirements of their respective viding quality service, controlling costs, focusing on asset uti- territories, control direct costs incurred locally, and execute the lization, committing to safety, and developing people. Precision corporate strategy and operating plan established by corporate Railroading is at the core of CN’s business model. It is a highly dis- management. ciplined process whereby CN handles individual rail shipments ac- See Note 15 - Segmented information, to the Company’s cording to a specific trip plan and manages all aspects of railroad 2011 Annual Consolidated Financial Statements for additional operations to meet customer commitments efficiently and profit- information on the Company’s corporate organization, as well as ably. Precision Railroading demands discipline to execute the trip selected financial information by geographic area. plan, the relentless measurement of results, and the use of such results to generate further execution improvements in the ser- vice provided to customers. Precision Railroading aims to increase Canadian National Railway Company U.S. GAAP 2011 Annual Report 9 Management’s Discussion and Analysis velocity, improve reliability, lower costs, enhance asset utilization improve productivity extend across all functions in the organiza- and, ultimately, help the Company to grow the top line. It has tion. Train productivity is being improved through the acquisition been a key contributor to CN’s earnings growth and improved of locomotives that are more fuel-efficient than the ones they return on invested capital. The success of the business model is replace, which will also improve service reliability for customers dependent on commercial principles and a supportive regulatory and reduce greenhouse gas emissions. In addition, the Company’s environment, both of which are key to an effective rail transpor- locomotives are being equipped with distributed power capability, tation marketplace throughout North America. which allows the Company to run longer, more efficient trains, particularly in cold weather conditions, while improving train han- Providing quality service, controlling costs and focusing on dling, reducing train separations and improving the overall safety asset utilization of operations. These initiatives, combined with CN’s investments The basic driver of the Company’s business is demand for reli- in longer sidings over the years, offer train-mile savings, allow able, efficient, and cost effective transportation. As such, the for efficient long-train operations and reduce wear on rail and Company’s focus is the pursuit of its long-term business plan, wheels. Yard throughput is being improved through SmartYard, providing a high level of service to customers, operating safe- an innovative use of real-time traffic information to sequence cars ly and efficiently, and meeting short- and long-term financial effectively and get them out on the line more quickly in the face commitments. of constantly changing conditions. In Engineering, the Company In 2011, the Company benefited from a continued recovery is continuously working to increase the productivity of its field in many markets reflecting a strengthening global economy, an forces, through better use of traffic information and the optimi- increase in North American industrial production, a turnaround zation of work scheduling, and as a result, better management in automotive production and a modest improvement in hous- of its engineering forces on the track. The Company also intends ing and related segments, as well as from the Company’s per- to continue focusing on the reduction of accidents and related formance above market conditions in a number of segments. In costs, as well as costs for legal claims and health care. 2012, the Company expects growth in North American industri- CN’s capital expenditure programs support the Company’s al production will slow to around three percent. The Company commitment to its core principles and strategy and its ability to expects moderate growth in automotive production, in part as grow the business profitably. In 2012, CN plans to invest approxi- Japanese automakers rebound from the supply chain disrup- mately $1.75 billion on capital programs, of which over $1 billion tions caused by the 2011 tsunami, and in U.S. housing starts. The is targeted towards track infrastructure to continue operating a 2012/2013 crops in both Canada and the U.S. are expected to be safe railway and improve the productivity and fluidity of the net- in-line with the 5-year average. With respect to the 2011/2012 work; and includes the replacement of rail, ties, and other track crop, U.S. corn and soybean production is slightly below, while materials, bridge improvements, as well as rail-line improvements exports are projected to be significantly below, the prior year’s for the Elgin, Joliet and Eastern Railway Company (EJ&E) prop- crop. Canadian 2011/2012 grain production and export forecasts erty that was acquired in 2009. This amount also includes funds are moderately above the prior year’s crop. for strategic initiatives and additional enhancements to the track To meet its business plan objectives, the Company’s priority infrastructure in western and eastern Canada as well as in the is to grow the business at low incremental cost. The Company’s U.S. CN’s equipment spending, targeted to reach approximately strategy to pursue deeper customer engagement and ser- $150 million in 2012, is intended to improve the quality of the vice improvements is expected to continue to drive growth. fleet to meet customer requirements. CN also expects to spend Improvements are expected to come from several key thrusts in- approximately $500 million on facilities to grow the business, in- cluding “first mile-last mile” initiatives that improve customer ser- cluding transloads, distribution centers and continued develop- vice at origin and destination, and a supply chain perspective that ment of its Calgary logistics park started in 2011; on information emphasizes collaboration and better end-to-end service. In 2012, technology to improve service and operating efficiency; and on the Company sees opportunities for growth in overseas container other projects to increase productivity. traffic, share gains against truck in domestic intermodal, growth To meet short- and long-term financial commitments, the in bulk commodities to export markets such as coal and potash Company pursues a solid financial policy framework with the goal and continued opportunities for growth in commodities related of maintaining a strong balance sheet by monitoring its credit ra- to oil and gas development. tios and preserving an investment-grade credit rating to be able To grow the business at low incremental cost and to operate to maintain access to public financing. The Company’s principal efficiently and safely while maintaining a high level of customer source of liquidity is cash generated from operations, which can service, the Company continues to invest in capital programs to be supplemented by its commercial paper program to meet short- maintain a safe and fluid railway and pursue strategic initiatives term liquidity needs. The Company’s primary uses of funds are for to improve its franchise, as well as undertake productivity initia- working capital requirements, including income tax installments tives to reduce costs and leverage its assets. Opportunities to as they become due and pension contributions, contractual 10 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis obligations, capital expenditures relating to track infrastructure In 2011, the Company’s sustainability practices have earned it a and other, acquisitions, dividend payouts, and the repurchase of place on the Dow Jones Sustainability Index (DJSI) North America shares through share buyback programs, when applicable. The for the third year in a row. Company sets priorities on its uses of available funds based on short-term operational requirements, expenditures to continue to Developing people operate a safe railway and pursue strategic initiatives, while also CN’s ability to develop the best railroaders in the industry has considering its long-term contractual obligations and returning been a key contributor to the Company’s success. CN recogniz- value to its shareholders. Delivering responsibly es that without the right people - no matter how good a ser- vice plan or business model a company may have - it will not be able to fully execute. The Company is focused on recruiting the The Company’s commitment to safety is reflected in the wide right people, developing employees with the right skills, motivat- range of initiatives that CN is pursuing and in the size of its capi- ing them to do the right thing, and training them to be the fu- tal programs. Comprehensive plans are in place to address safety, ture leaders of the Company. The Company continues to address security, employee well-being and environmental management. changes in employee demographics that will span multiple years. CN’s Safety Management Plan is the framework for putting safety The Human Resources and Compensation Committee of the at the center of its day-to-day operations. This proactive plan is Board of Directors reviews the progress made in developing cur- designed to minimize risk and drive continuous improvement in rent and future leaders through the Company’s leadership devel- the reduction of injuries and accidents, and engages employees opment programs. These programs and initiatives provide a solid at all levels of the organization. platform for the assessment and development of the Company’s The Company has made sustainability an integral part of its talent pool. The leadership development programs are tightly in- business strategy by aligning its sustainability agenda with its tegrated with the Company’s business strategy. business model. As part of the Company’s comprehensive sus- tainability action plan and to comply with the CN Environmental The forward-looking statements provided in the above section and Policy, the Company engages in a number of initiatives, includ- in other parts of this MD&A are subject to risks and uncertainties ing the use of fuel-efficient locomotives that reduce greenhouse that could cause actual results or performance to differ materially gas emissions; increasing operational and building efficiencies; from those expressed or implied in such statements and are based investing in virtualization technologies, energy-efficient data on certain factors and assumptions which the Company considers centers and recycling programs for information technology sys- reasonable, about events, developments, prospects and oppor- tems; reducing, recycling and reusing waste at its facilities and tunities that may not materialize or that may be offset entirely or on its network; engaging in modal shift agreements that favor partially by other events and developments. See the section of this low emission transport services; and participating in the Carbon MD&A entitled Forward-looking statements for assumptions and Disclosure Project to gain a more comprehensive view of its car- risk factors affecting such forward-looking statements. bon footprint. The Company’s Environmental Policy aims to minimize the Impact of foreign currency translation on reported results impact of the Company’s activities on the environment. The Although the Company conducts its business and reports its earn- Company strives to contribute to the protection of the environ- ings in Canadian dollars, a large portion of revenues and expenses ment by integrating environmental priorities into the Company’s is denominated in US dollars. As such, the Company’s results are overall business plan and through the specific monitoring and affected by exchange-rate fluctuations. measurement of such priorities against historical performance and Management’s discussion and analysis includes reference in some cases, specific targets. All employees must demonstrate to “constant currency,” which allows the financial results to be commitment to this Policy at all times and it is the Environment, viewed without the impact of fluctuations in foreign exchange Safety and Security Committee of the Board of Directors who has rates, thereby facilitating period-to-period comparisons in the the responsibility of overseeing the Policy. The Committee is com- analysis of trends in business performance. Financial results at posed of CN Directors and its responsibilities, powers and opera- constant currency are obtained by translating the current period tion are further described in the charter of such committee, which results denominated in US dollars at the foreign exchange rate is included in the Company’s Corporate Governance Manual of the comparable period of the prior year. The average foreign available on CN’s website. Certain risk mitigation strategies, such exchange rate for the year ended December 31, 2011 was $0.99 as periodic audits, employee training programs and emergency per US$1.00 compared to $1.03 per US$1.00 for 2010. Measures plans and procedures, are in place to minimize the environmen- at constant currency are considered non-GAAP measures and do tal risks to the Company. The Company’s Environmental Policy, its not have any standardized meaning prescribed by GAAP and may, Carbon Disclosure Project report, and its Corporate Citizenship therefore, not be comparable to similar measures presented by Report “Delivering Responsibly” are available on CN’s website. other companies. Canadian National Railway Company U.S. GAAP 2011 Annual Report 11 Management’s Discussion and Analysis Forward-looking statements Certain information included in this MD&A are “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995 and under Canadian securities laws. CN cautions that, by their nature, forward-looking statements involve risks, uncertainties and assumptions. The Company cautions that its assumptions may not materialize and that current economic conditions render such assumptions, although reasonable at the time they were made, subject to greater uncertainty. These forward-looking state- ments include, but are not limited to, statements with respect to growth opportunities; statements that the Company will benefit from growth in North American and global economies; the anticipation that cash flow from operations and from various sources of financing will be sufficient to meet debt repayments and future obligations in the foreseeable future; statements regarding future payments, including income taxes and pension contributions; as well as the projected capital spending program. Forward-looking statements could further be identified by the use of terminology such as the Company “believes,” “expects,” “anticipates” or other similar words. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company or the rail industry to be materially different from the out- look or any future results or performance implied by such statements. Key assumptions used in determining forward-looking information are set forth below. Forward-looking statements Key assumptions or expectations Statements relating to general economic and business conditions, including those referring to revenue growth opportunities • North American and global economic growth • Long-term growth opportunities being less affected by current economic conditions • Year-over-year carload growth Statements relating to the Company's ability to meet debt repayments and future obligations in the foreseeable future, including income tax payments and capital spending • North American and global economic growth • Adequate credit ratios • Investment grade credit rating • Access to capital markets • Adequate cash generated from operations Statements relating to pension contributions • Adequate cash generated from operations and other sources of financing • Adequate long-term return on investment on pension plan assets • Level of funding as determined by actuarial valuations, particularly influenced by discount rates for funding purposes Important risk factors that could affect the forward-looking statements include, but are not limited to, the effects of general economic and business conditions; industry competition; inflation, currency and interest rate fluctuations; changes in fuel prices; legislative and/or regula- tory developments; compliance with environmental laws and regulations; actions by regulators; various events which could disrupt opera- tions, including natural events such as severe weather, droughts, floods and earthquakes; labor negotiations and disruptions; environmental claims; uncertainties of investigations, proceedings or other types of claims and litigation; risks and liabilities arising from derailments; and other risks detailed from time to time in reports filed by CN with securities regulators in Canada and the United States. See the section of this MD&A entitled Business risks for detailed information on major risk factors. CN assumes no obligation to update or revise forward-looking statements to reflect future events, changes in circumstances, or changes in beliefs, unless required by applicable Canadian securities laws. In the event CN does update any forward-looking statement, no inference should be made that CN will make additional updates with respect to that statement, related matters, or any other forward-looking statement. Financial outlook During the year, the Company issued and updated its financial outlook. The 2011 actual results are in line with the latest financial outlook as disclosed by the Company. 12 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Financial and statistical highlights $ in millions, except per share data, or unless otherwise indicated 2011 2010 2009 2011 vs. 2010 2010 vs. 2009 Change Favorable/(Unfavorable) Financial results Revenues Operating income (1) Net income (1) (2) (3) (4) Operating ratio (1) Basic earnings per share (1) (2) (3) (4) Diluted earnings per share (1) (2) (3) (4) Dividend declared per share Financial position Total assets Total long-term financial liabilities $ 9,028 $ 8,297 $ 7,367 $ 3,296 $ 3,024 $ 2,406 $ 2,457 $ 2,104 $ 1,854 9% 9% 17% 13% 26% 13% 63.5% 63.6% 67.3% 0.1-pts 3.7-pts $ 5.45 $ 4.51 $ 3.95 $ 5.41 $ 4.48 $ 3.92 $ 1.30 $ 1.08 $ 1.01 $ 26,026 $ 25,206 $ 25,176 $ 13,631 $ 12,016 $ 12,706 21% 21% 20% 3% (13%) 5% - 1% 14% 14% 7% - 5% 1% 11% 3% Statistical operating data and productivity measures (5) Employees (average for the year) 22,985 21,967 21,793 Gross ton miles (GTM) per average number of employees (thousands) 15,572 15,533 13,981 GTMs per US gallon of fuel consumed 973 959 931 (1) The 2009 figures include $49 million, or $30 million after-tax ($0.06 per basic or diluted share), for EJ&E acquisition-related costs. (2) The 2011 figures include a net deferred income tax expense of $40 million ($0.08 per basic or diluted share) resulting from the enactment of state corporate income tax rate changes and other legislated state tax revisions, a current income tax recovery of $11 million ($0.02 per basic or diluted share) relating to certain fuel costs attributed to various wholly-owned subsidiaries’ fuel consumption in prior periods, a gain on disposal of a segment of the Company’s Kingston subdivision known as the Lakeshore East of $288 million, or $254 million after-tax ($0.55 per basic or diluted share), and a gain on disposal of substantially all of the assets of IC RailMarine Terminal Company (ICRMT) of $60 million, or $38 million after-tax ($0.08 per basic or diluted share). (3) The 2010 figures include a gain on disposal of a portion of the property known as the Oakville subdivision of $152 million, or $131 million after-tax ($0.28 per basic or diluted share). (4) The 2009 figures include gains on sale of the Company’s Weston subdivision of $157 million, or $135 million after-tax ($0.29 per basic or diluted share) and Lower Newmarket subdivision of $69 million, or $59 million after-tax ($0.12 per basic or diluted share). The 2009 figures also include a deferred income tax recovery of $157 million ($0.33 per basic or diluted share), of which $126 million ($0.27 per basic or diluted share) resulted from the enactment of lower provincial corporate income tax rates, $16 million ($0.03 per basic or diluted share) resulted from the recapitalization of a foreign investment, and $15 million ($0.03 per basic or diluted share) resulted from the resolution of various income tax matters and adjustments related to tax filings of prior years. (5) Based on estimated data available at such time and subject to change as more complete information becomes available. Financial results 2011 compared to 2010 conversion of the Company’s US dollar-denominated revenues and expenses, has resulted in a negative impact of $39 million In 2011, net income was $2,457 million, an increase of $353 mil- ($0.09 per basic or diluted share) in 2011. lion, or 17%, when compared to 2010, with diluted earnings per Revenues for the year ended December 31, 2011 increased share rising 21% to $5.41. by $731 million, or 9%, to $9,028 million, mainly attributable Included in the 2011 figures were gains on disposal of substan- to higher freight volumes, due in part to modest improvements tially all of the assets of IC RailMarine Terminal Company (ICRMT) in North American and global economies and to the Company’s of $60 million, or $38 million after-tax ($0.08 per basic or diluted performance above market conditions in a number of segments; share) and of a segment of the Company’s Kingston subdivision the impact of a higher fuel surcharge as a result of year-over-year known as the Lakeshore East of $288 million, or $254 million after- increases in applicable fuel prices and higher volumes; and freight tax ($0.55 per basic or diluted share). The 2011 figures also include rate increases. These factors were partly offset by the negative a net deferred income tax expense of $40 million ($0.08 per basic translation impact of the stronger Canadian dollar on US dollar- or diluted share) resulting from the enactment of state corporate denominated revenues in the first nine months of the year. income tax rate changes and other legislated state tax revisions, Operating expenses for the year ended December 31, 2011, in- and a current income tax recovery of $11 million ($0.02 per ba- creased by $459 million, or 9%, to $5,732 million, mainly due to sic or diluted share) relating to certain fuel costs attributed to vari- higher fuel costs, purchased services and material expense as well as ous wholly-owned subsidiaries’ fuel consumption in prior periods. higher labor and fringe benefits expense. These factors were partially Included in the 2010 figures was a gain on disposal of a portion of offset by the positive translation impact of the stronger Canadian the property known as the Oakville subdivision of $152 million, or dollar on US dollar-denominated expenses, particularly in the first $131 million after-tax ($0.28 per basic or diluted share). nine months of 2011 and lower casualty and other expense. Foreign exchange fluctuations continue to have an impact on The operating ratio, defined as operating expenses as a per- the comparability of the results of operations. The fluctuation of centage of revenues, was 63.5% in 2011, compared to 63.6% in the Canadian dollar relative to the US dollar, which affects the 2010, a 0.1-point reduction. Canadian National Railway Company U.S. GAAP 2011 Annual Report 13 Management’s Discussion and Analysis Revenues In millions, unless otherwise indicated Year ended December 31, 2011 2010 % Change % Change at constant currency Rail freight revenues $ 8,111 $ 7,417 917 880 9% 4% 12% 6% $ 9,028 $ 8,297 9% 11% Other revenues Total revenues Rail freight revenues Petroleum and chemicals $ 1,420 $ 1,322 7% Metals and minerals 1,006 861 17% Forest products 1,270 1,183 Coal 618 600 Grain and fertilizers 1,523 1,418 7% 3% 7% Intermodal Automotive 1,790 1,576 14% 484 457 6% 10% 20% 10% 5% 10% 15% 9% Total rail freight revenues $ 8,111 $ 7,417 9% 12% Revenue ton miles (RTM) (millions) 187,753 179,232 Rail freight revenue/RTM (cents) Carloads (thousands) 4.32 4.14 4,873 4,696 Rail freight revenue/carload (dollars) 1,664 1,579 5% 4% 4% 5% 5% 7% 4% 8% Petroleum and chemicals Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 1,420 $ 1,322 RTMs (millions) 32,962 31,190 Revenue/RTM (cents) 4.31 4.24 7% 6% 2% 10% 6% 4% The petroleum and chemicals commodity group comprises a wide range of commodities, including chemicals, sulfur, plastics, petroleum products and liquefied petroleum gas (LPG) products. The primary markets for these commodities are within North America, and as such, the performance of this commodity group is closely correlated with the North American economy. Most of the Company’s petroleum and chemicals shipments originate in the Louisiana petrochemical corridor between New Orleans and Baton Rouge; in northern Alberta, which is a major center for natural gas feedstock and world-scale petrochemicals and plas- tics; and in eastern Canadian regional plants. For the year ended December 31, 2011, revenues for this commodity group increased by $98 million, or 7%, when compared to 2010. The increase was mainly due to higher shipments, particularly chemicals products, as a result of improvements in industrial production, new crude oil business, particularly in the fourth quarter, and refined petroleum products; the impact of a higher fuel surcharge; and freight rate Revenues for the year ended December 31, 2011 totaled increases. These factors were partly offset by the negative trans- $9,028 million compared to $8,297 million in 2010. The increase lation impact of the stronger Canadian dollar and lower volumes of $731 million was mainly attributable to higher freight volumes, of condensate in the first half of the year. Revenue per revenue due in part to modest improvements in North American and ton mile increased by 2% in 2011, mainly due to the impact of a global economies and to the Company’s performance above mar- higher fuel surcharge and freight rate increases that were partly ket conditions in a number of segments; the impact of a higher offset by the negative translation impact of the stronger Canadian fuel surcharge, in the range of $315 million, as a result of year- dollar and an increase in the average length of haul. over-year increases in applicable fuel prices and higher volumes; and freight rate increases. These factors were partly offset by the Percentage of revenues Carloads (thousands) negative translation impact of the stronger Canadian dollar on US dollar-denominated revenues in the first nine months of the year. In 2011, revenue ton miles (RTM), measuring the relative weight and distance of rail freight transported by the Company, increased by 5% relative to 2010. Rail freight revenue per revenue ton mile, a measurement of yield defined as revenue earned on 49% Petroleum 36% Chemicals 15% Plastics 49% 36% the movement of a ton of freight over one mile, increased by 4% 15% when compared to 2010, driven by the impact of a higher fuel surcharge and freight rate increases. These were partly offset by the negative translation impact of the stronger Canadian dollar. Year ended December 31, 2009 511 2010 549 2011 560 0 100 200 300 400 500 600 14 2011 Annual Report U.S. GAAP Management’s Discussion and Analysis Metals and minerals Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 1,006 $ 861 17% RTMs (millions) 18,899 16,443 15% Revenue/RTM (cents) 5.32 5.24 2% 20% 15% 5% The metals and minerals com- Forest products modity group consists primar- ily of non-ferrous base metals and ores, concentrates, iron ore, steel, construction materi- als, machinery and dimensional (large) loads. The Company pro- Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 1,270 $ 1,183 RTMs (millions) 29,336 28,936 Revenue/RTM (cents) 4.33 4.09 7% 1% 6% 10% 1% 9% vides unique rail access to alu- The forest products commodity group includes various types of minum, mining, steel and iron lumber, panels, paper, wood pulp and other fibers such as logs, ore producing regions, which recycled paper, wood chips, and wood pellets. The Company has are among the most important extensive rail access to the western and eastern Canadian fiber- in North America. This access, producing regions, which are among the largest fiber source areas coupled with the Company’s in North America. In the United States, the Company is strategi- transload and port facilities, has made CN a leader in the trans- portation of copper, lead, zinc, cally located to serve both the Midwest and southern U.S. corri- dors with interline connections to other Class I railroads. The key drivers for the various commodities are: for newsprint, advertising concentrates, iron ore, refined lineage, non-print media and overall economic conditions, primar- metals and aluminum. Mining, ily in the United States; for fibers (mainly wood pulp), the con- oil and gas development and sumption of paper, pulpboard and tissue in North American and non-residential construction are offshore markets; and for lumber and panels, housing starts and the key drivers for metals and renovation activities primarily in the United States. For the year minerals. For the year ended December 31, 2011, revenues for ended December 31, 2011, revenues for this commodity group this commodity group increased by $145 million, or 17%, when increased by $87 million, or 7%, when compared to 2010. The compared to 2010. The increase was mainly due to greater ship- increase was attributable to the impact of a higher fuel surcharge; ments, particularly of commodities related to oil and gas develop- freight rate increases; higher lumber and wood pellet shipments ment, steel-related products and non-ferrous ore; the impact of to offshore markets, and increased panel shipments to the U.S., freight rate increases; and a higher fuel surcharge. These gains particularly in the fourth quarter. These factors were partly offset were partly offset by the negative translation impact of the stron- by the negative translation impact of the stronger Canadian dollar ger Canadian dollar. Revenue per revenue ton mile increased by and reduced volumes of wood pulp in the second half of the year 2% in 2011, mainly due to the impact of freight rate increases due to extended maintenance at various mills. Revenue per rev- and a higher fuel surcharge that were offset by the negative enue ton mile increased by 6% in 2011, mainly due to the impact translation impact of the stronger Canadian dollar and a signifi- of a higher fuel surcharge, freight rate increases and a decrease in cant increase in the average length of haul. the average length of haul. These factors were partly offset by the negative translation impact of the stronger Canadian dollar. Percentage of revenues Carloads (thousands) 44% Metals 37% Minerals 19% Iron ore 44% 37% 19% Year ended December 31, Percentage of revenues Carloads (thousands) 2009 721 2010 990 2011 1,013 59% Pulp and paper Year ended December 31, 41% Lumber and panels 59% 41% 2009 403 2010 423 2011 443 Canadian National Railway Company U.S. GAAP 0 0 200 400 600 800 1000 1200 100 2011 Annual Report 15 400 200 300 500 Management’s Discussion and Analysis Coal Grain and fertilizers Year ended December 31, 2011 2010 % Change % Change at constant currency Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 618 $ 600 RTMs (millions) 19,980 19,766 Revenue/RTM (cents) 3.09 3.04 3% 1% 2% 5% 1% 4% Revenues (millions) $ 1,523 $ 1,418 RTMs (millions) 45,468 44,549 Revenue/RTM (cents) 3.35 3.18 7% 2% 5% 10% 2% 8% The coal commodity group con- The grain and fertilizers commodity group depends primarily on crops sists of thermal grades of bitumi- grown and fertilizers processed in western Canada and the U.S. nous coal, metallurgical coal and Midwest. The grain segment consists of three primary segments: food petroleum coke. Canadian thermal grains (mainly wheat, oats and malting barley), feed grains (including coal is delivered to power utilities feed barley, feed wheat, peas, corn, ethanol and dried distillers grains primarily in eastern Canada; while (DDG)), and oilseeds and oilseed products (primarily canola seed, oil in the United States, thermal coal and meal, and soybeans). Production of grain varies considerably is transported from mines served from year to year, affected primarily by weather conditions, seeded in southern Illinois, or from west- and harvested acreage, the mix of grains produced and crop yields. ern U.S. mines via interchange Grain exports are sensitive to the size and quality of the crop pro- with other railroads, to major utili- duced, international market conditions and foreign government policy. ties in the Midwest and southeast The majority of grain produced in western Canada and moved by CN United States, as well as offshore is exported via the ports of Vancouver, Prince Rupert and Thunder markets. The coal business also in- Bay. Certain of these rail movements are subject to government regu- cludes the transport of Canadian lation and to a revenue cap, which effectively establishes a maximum metallurgical coal, which is largely revenue entitlement that railways can earn. In the U.S., grain grown exported via terminals on the west in Illinois and Iowa is exported as well as transported to domestic pro- coast of Canada to offshore steel cessing facilities and feed markets. The Company also serves major producers. For the year ended producers of potash in Canada, as well as producers of ammonium December 31, 2011, revenues for nitrate, urea and other fertilizers across Canada and the U.S. For the this commodity group increased year ended December 31, 2011, revenues for this commodity group by $18 million, or 3%, when com- increased by $105 million, or 7%, when compared to 2010. The in- pared to 2010. The increase was crease was mainly due to freight rate increases; the impact of a higher mainly due to the impact of a higher fuel surcharge; freight rate fuel surcharge; and higher volumes, including record shipments increases; and new export thermal coal shipments. These factors of canola to export markets and processed canola products to the were partly offset by reduced volumes of thermal coal to North U.S., increased shipments of ethanol and DDG, and higher volumes American utilities, export metallurgical coal and Canadian petro- of Canadian oats to U.S. millers. These factors were partly offset by leum coke; and the negative translation impact of the stronger the negative translation impact of the stronger Canadian dollar; re- Canadian dollar. Revenue per revenue ton mile increased by 2% duced volumes of U.S. soybean and corn exports, mainly in the fourth in 2011, primarily due to the impact of a higher fuel surcharge quarter, and lower volumes of Canadian wheat for export markets, and freight rate increases that were partly offset by the negative particularly in the first half of the year. Revenue per revenue ton mile translation impact of the stronger Canadian dollar and an in- increased by 5% in 2011, mainly due to freight rate increases and the crease in the average length of haul. impact of a higher fuel surcharge that were partly offset by the nega- Percentage of revenues Carloads (thousands) 89% Coal Year ended December 31, Percentage of revenues Carloads (thousands) tive translation impact of the stronger Canadian dollar. 11% Petroleum coke 11% 89% 2009 426 2010 499 2011 464 31% Oilseeds 25% Food grains 25% Feed grains 19% Fertilizers 31% 25% 19% 25% Year ended December 31, 2009 530 2010 579 2011 592 16 2011 Annual Report U.S. GAAP 0 100 200 300 400 500 0 Canadian National Railway Company 100 200 300 400 500 600 Management’s Discussion and Analysis Automotive Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 484 $ 457 RTMs (millions) 2,545 2,545 Revenue/RTM (cents) 19.02 17.96 6% - 6% 9% - 9% The automotive commodity group moves both finished vehicles and parts through- out North America, providing rail ac- cess to certain vehicle assembly plants in Canada, and Michigan and Mississippi in the U.S. The Company also serves vehicle distribution facilities in Canada and the U.S., as well as parts production facilities in Michigan and Ontario. The Company serves shippers of import vehicles via the ports of Halifax and Vancouver, and through interchange with other railroads. The Company’s automotive revenues are closely correlated to automotive produc- tion and sales in North America. For the year ended December 31, 2011, revenues Intermodal Year ended December 31, 2011 2010 % Change % Change at constant currency Revenues (millions) $ 1,790 $ 1,576 14% 15% RTMs (millions) 38,563 35,803 Revenue/RTM (cents) 4.64 4.40 8% 5% 8% 6% The intermodal commodity group is comprised of two segments: domestic and international. The domestic segment transports consumer products and manufactured goods, operating through both retail and wholesale channels, within domestic Canada, do- mestic U.S., Mexico and transborder, while the international seg- ment handles import and export container traffic, directly serving the major ports of Vancouver, Prince Rupert, Montreal, Halifax and New Orleans. The domestic segment is driven by consumer mar- kets, with growth generally tied to the economy. The international segment is driven by North American economic and trade condi- tions. For the year ended December 31, 2011, revenues for this commodity group increased by $214 million, or 14%, when com- for this commodity group increased by $27 million, or 6%, when pared to 2010. The increase was mainly due to higher volumes compared to 2010. The increase was mainly due to higher vol- of domestic traffic and shipments related to overseas markets; umes of domestic finished vehicles; freight rate increases; and the the impact of a higher fuel surcharge; and freight rate increases. impact of a higher fuel surcharge. These gains were partly offset These factors were partly offset by the negative translation impact by the negative translation impact of the stronger Canadian dol- of the stronger Canadian dollar. Revenue per revenue ton mile in- lar. Revenue per revenue ton mile increased by 6% in 2011, mainly creased by 5% in 2011, mainly due to the impact of a higher fuel due to freight rate increases, the impact of a higher fuel surcharge surcharge and freight rate increases that were partly offset by the and a decrease in the average length of haul that were partly offset negative translation impact of the stronger Canadian dollar. by the negative translation impact of the stronger Canadian dollar. Percentage of revenues Carloads (thousands) Percentage of revenues Carloads (thousands) Year ended December 31, 89% Finished vehicles Year ended December 31, 2009 1,246 2010 1,455 2011 1,584 11% Auto parts 11% 89% 2009 154 2010 201 2011 217 56% International 44% Domestic 56% 44% Other revenues Year ended December 31, 2011 0 2010 % Change 400 800 % Change at constant currency 1200 1600 Other revenues are largely derived from non-rail services that support CN’s rail business including vessels, docks, warehousing, Autoport logistic service and trucking as well as from other items which include interswitching and commuter train revenues. In 0 200 100 150 50 250 Revenues (millions) $ 917 $ 880 4% 6% 2011, Other revenues amounted to $917 million, an increase of Percentage of revenues 48% Other non-rail services 31% Vessels and docks 21% Interswitching and other revenues 48% 31% 21% $37 million, or 4%, when compared to 2010, mainly due to in- creased revenues from vessels and docks, trucking, and warehous- ing and distribution services, partly offset by lower international freight forwarding revenues, the negative translation impact of the stronger Canadian dollar, and lower commuter train revenues. Canadian National Railway Company U.S. GAAP 2011 Annual Report 17 Management’s Discussion and Analysis Operating expenses Operating expenses for the year ended December 31, 2011 amounted to $5,732 million, compared to $5,273 million in 2010. The increase of $459 million, or 9%, in 2011 was mainly due to higher fuel costs, purchased services and material expense, labor and fringe benefits ex- pense as well as higher depreciation and amortization. These factors were partially offset by the positive translation impact of the stronger Canadian dollar on US dollar-denominated expenses, particularly in the first nine months of 2011 and lower casualty and other expense. In millions Year ended December 31, 2011 2010 % Change Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses $ 1,812 $ 1,744 1,120 1,412 884 228 276 1,036 1,048 834 243 368 $ 5,732 $ 5,273 (4%) (8%) (35%) (6%) 6% 25% (9%) % Change at constant currency Percentage of revenues 2011 2010 (6%) 20.1% 21.0% (10%) 12.4% 12.5% (40%) 15.6% 12.6% (7%) 3% 23% 9.8% 2.5% 3.1% 10.1% 2.9% 4.5% (11%) 63.5% 63.6% Labor and fringe benefits: Labor and fringe benefits expense in- Fuel: Fuel expense includes fuel consumed by assets, including cludes wages, payroll taxes, and employee benefits such as incen- locomotives, vessels, vehicles and other equipment as well as tive compensation, including stock-based compensation; health provincial, federal and state fuel taxes. These expenses increased and welfare; and pensions and other postretirement benefits. by $364 million, or 35%, in 2011 when compared to 2010. The Certain incentive and stock-based compensation plans are based increase was primarily due to a higher average price for fuel and on financial and market performance targets and the related ex- higher freight volumes, which were partly offset by the positive pense is recorded in relation to the attainment of such targets. translation impact of the stronger Canadian dollar and by produc- Labor and fringe benefits expense increased by $68 million, or tivity improvements. 4%, in 2011 when compared to 2010. The increase was primar- ily due to the impact of increased freight volumes, including a Depreciation and amortization: Depreciation and amortization higher workforce level, general wage increases, higher health and expense relates to the Company’s rail and related operations. welfare costs, as well as higher incentive compensation, particu- Depreciation expense is affected by capital additions, railroad larly in the fourth quarter. These factors were partly offset by the property retirements from disposal, sale and/or abandonment and positive translation impact of the stronger Canadian dollar and a other adjustments including asset impairment write-downs. These higher income for pensions. expenses increased by $50 million, or 6%, in 2011 when com- pared to 2010. The increase was mainly due to the impact of net Purchased services and material: Purchased services and material capital additions and the effect of depreciation studies (see the expense primarily includes the costs of services purchased from Critical accounting policies section of this MD&A), which were outside contractors; materials used in the maintenance of the partly offset by the positive translation impact of the stronger Company’s track, facilities and equipment, transportation and Canadian dollar. lodging for train crew employees; utility costs; and the net costs of operating facilities jointly used by the Company and other rail- Equipment rents: Equipment rents expense includes rental ex- roads. These expenses increased by $84 million, or 8%, in 2011 pense for the use of freight cars owned by other railroads or pri- when compared to 2010. The increase was mainly due to high- vate companies and for the short- or long-term lease of freight er repair and maintenance expenses for track, rolling stock and cars, locomotives and intermodal equipment, net of rental in- other equipment, higher derailment related expenses, increased come from other railroads for the use of the Company’s cars and contracted services and material expense in the first nine months locomotives. These expenses decreased by $15 million, or 6%, in of the year as well as higher costs for snow removal and utilities, 2011 when compared to 2010. The decrease was primarily due to as a result of more difficult winter conditions in the first quarter lower lease expense and to the positive translation impact of the of 2011. These factors were partly offset by the positive transla- stronger Canadian dollar partly offset by higher car hire expense. tion impact of the stronger Canadian dollar and lower expenses for third party carriers. 18 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Casualty and other: Casualty and other expense includes ex- Included in the 2010 figures was a gain on sale of the Company’s penses for personal injuries, environmental, freight and property Oakville subdivision of $152 million, or $131 million after-tax ($0.28 damage, insurance, bad debt, operating taxes, and travel expens- per basic or diluted share). Included in the 2009 figures were gains es. These expenses decreased by $92 million, or 25%, in 2011 on sale of the Company’s Weston subdivision of $157 million, or when compared to 2010. The decrease was mainly due to lower $135 million after-tax ($0.29 per basic or diluted share) and Lower charges recorded in 2011 relating to environmental matters, ad- Newmarket subdivision of $69 million, or $59 million after-tax justments recorded on billings of certain cost recoveries recorded ($0.12 per basic or diluted share), as well as EJ&E acquisition-relat- in 2010, lower general and administrative expenses as well as a ed costs of $49 million, or $30 million after-tax ($0.06 per basic or charge recorded in the first quarter of 2010 to increase the liabil- diluted share). The 2009 figures also include a deferred income tax ity for personal injury claims in Canada pursuant to an actuarial recovery of $157 million ($0.33 per basic or diluted share), of which valuation. These factors were partially offset by increased employ- $126 million ($0.27 per basic or diluted share) resulted from the en- ee travel costs and higher operating taxes. actment of lower provincial corporate income tax rates, $16 million Other ($0.03 per basic or diluted share) resulted from the recapitalization of a foreign investment, and $15 million ($0.03 per basic or diluted Interest expense: Interest expense decreased by $19 million, or share) resulted from the resolution of various income tax matters and 5%, for the year ended December 31, 2011, when compared to adjustments related to tax filings of prior years. 2010, mainly due to the positive translation impact of the stronger Foreign exchange fluctuations continue to have an impact on Canadian dollar on US dollar-denominated interest expense and the comparability of the results of operations. The fluctuation of the impact of a debt repayment in the fourth quarter of 2011. the Canadian dollar relative to the US dollar, which affects the conversion of the Company’s US dollar-denominated revenues Other income: In 2011, the Company recorded Other income and expenses, has resulted in a negative impact of $70 million to of $401 million, compared to $212 million in 2010. Included in net income ($0.15 per basic or diluted share) in 2010. Other income were gains on disposal of substantially all of the as- Revenues for the year ended December 31, 2010 increased by sets of ICRMT of $60 million and of a segment of the Company’s $930 million, or 13%, to $8,297 million, mainly due to signifi- Kingston subdivision known as the Lakeshore East for $288 mil- cantly higher freight volumes as a result of improving economic lion. The 2010 figures include $152 million for the sale of a por- conditions in North America and globally; the impact of a higher tion of the property known as the Oakville subdivision. fuel surcharge as a result of year-over-year increases in applicable fuel prices and higher volumes; and freight rate increases. These Income tax expense: The Company recorded income tax expense factors were partly offset by the negative translation impact of of $899 million for the year ended December 31, 2011 com- the stronger Canadian dollar on US dollar-denominated revenues. pared to $772 million in 2010. The 2011 figure includes a net Operating expenses for the year ended December 31, 2010 deferred income tax expense of $40 million resulting from the increased by $312 million, or 6%, to $5,273 million, primarily enactment of state corporate income tax rate changes and other due to higher fuel costs, increased labor and fringe benefits ex- legislated state tax revisions, and a current income tax recovery pense and higher depreciation and amortization expense. These of $11 million relating to certain fuel costs attributed to various factors were partly offset by the positive translation impact of the wholly-owned subsidiaries’ fuel consumption in prior periods. The stronger Canadian dollar on US dollar-denominated expenses, effective tax rate for 2011 was 26.8% for both 2011 and 2010. the impact of EJ&E acquisition-related costs recorded in 2009 and Excluding the 2011 net deferred income tax expense of $40 mil- lower equipment rents. lion and the current income tax recovery of $11 million discussed The operating ratio, defined as operating expenses as a per- herein, the effective tax rate for 2011 was 25.9%. centage of revenues, was 63.6% in 2010, compared to 67.3% in 2010 compared to 2009 2009, a 3.7-point improvement. Excluding the 2009 EJ&E acqui- sition-related costs, the operating ratio of 63.6% in 2010 repre- In 2010, net income was $2,104 million, an increase of $250 mil- sents a 3.1-point improvement compared to an adjusted operat- lion, or 13%, when compared to 2009, with diluted earnings per ing ratio of 66.7% in 2009. share rising 14% to $4.48. The Company’s results of operations in 2010 reflect a re- covery in many of its markets as compared to 2009 when the Company experienced significant weakness across markets due to economic conditions. Canadian National Railway Company U.S. GAAP 2011 Annual Report 19 Management’s Discussion and Analysis Revenues In millions, unless otherwise indicated Year ended December 31, 2010 2009 % Change % Change at constant currency Rail freight revenues $ 7,417 $ 6,632 12% 880 735 20% $ 8,297 $ 7,367 13% 19% 18% 26% Other revenues Total revenues Rail freight revenues Petroleum and chemicals $ 1,322 $ 1,260 5% Metals and minerals 861 728 18% Forest products 1,183 1,147 3% Coal 600 464 29% Grain and fertilizers 1,418 1,341 6% Intermodal Automotive 1,576 1,337 18% 457 355 29% 12% 27% 11% 35% 11% 20% 39% For the year ended December 31, 2010, revenues for this com- modity group increased by $62 million, or 5%, when compared to 2009. The increase was mainly due to higher shipments of chemical products, due to improvements in industrial production, and sulfur and petroleum products; freight rate increases; and the impact of a higher fuel surcharge. These factors were partly off- set by the negative translation impact of the stronger Canadian dollar. Revenue per revenue ton mile decreased by 1% in 2010, mainly due to the negative translation impact of the stronger Canadian dollar, that was partly offset by freight rate increases and the impact of a higher fuel surcharge. Metals and minerals Year ended December 31, 2010 2009 % Change % Change at constant currency Total rail freight revenues $ 7,417 $ 6,632 12% 18% Revenues (millions) $ 861 $ 728 18% Revenue ton miles (RTM) RTMs (millions) 16,443 12,994 27% (millions) 179,232 159,862 12% 12% Revenue/RTM (cents) 5.24 5.60 (6%) 27% 27% 1% 4.14 4.15 - 5% For the year ended December 31, 2010, revenues for this com- Rail freight revenue/RTM (cents) Carloads (thousands) Rail freight revenue/carload 4,696 3,991 18% 18% (dollars) 1,579 1,662 (5%) - modity group increased by $133 million, or 18%, when com- pared to 2009. The increase was mainly due to the continual improvement in the steel industry, which resulted in greater ship- ments of steel products and iron ore; stronger volumes of con- Revenues for the year ended December 31, 2010 totaled struction materials; and the impact of a higher fuel surcharge. $8,297 million compared to $7,367 million in 2009. The increase These factors were partly offset by the negative translation im- of $930 million was mainly due to significantly higher freight pact of the stronger Canadian dollar. Revenue per revenue ton volumes as a result of improving economic conditions in North mile decreased by 6% in 2010, mainly due to the negative trans- America and globally; the impact of a higher fuel surcharge, in lation impact of the stronger Canadian dollar that was partly off- the range of $240 million, as a result of year-over-year increases set by the impact of a higher fuel surcharge and a decrease in the in applicable fuel prices and higher volumes; and freight rate average length of haul. increases. These factors were partly offset by the negative trans- lation impact of the stronger Canadian dollar on US dollar- Forest products denominated revenues, particularly in the first half of the year. In 2010, revenue ton miles (RTM), measuring the relative weight and distance of rail freight transported by the Company, increased Year ended December 31, 2010 2009 % Change % Change at constant currency by 12% relative to 2009. Rail freight revenue per revenue ton mile, Revenues (millions) $ 1,183 $ 1,147 a measurement of yield defined as revenue earned on the move- RTMs (millions) 28,936 27,594 ment of a ton of freight over one mile, was flat when compared to Revenue/RTM (cents) 4.09 4.16 3% 5% (2%) 11% 5% 6% 2009, as the positive impact of a higher fuel surcharge, freight rate increases, and a decrease in the average length of haul were offset by the negative translation impact of the stronger Canadian dollar. Petroleum and chemicals Year ended December 31, 2010 2009 % Change % Change at constant currency Revenues (millions) $ 1,322 $ 1,260 RTMs (millions) 31,190 29,381 Revenue/RTM (cents) 4.24 4.29 5% 6% (1%) 12% 6% 6% For the year ended December 31, 2010, revenues for this com- modity group increased by $36 million, or 3%, when compared to 2009. The increase was mainly due to higher shipments of wood pulp and lumber to offshore markets, the impact of a high- er fuel surcharge, and freight rate increases. These factors were partly offset by the negative translation impact of the stronger Canadian dollar. Revenue per revenue ton mile decreased by 2% in 2010, mainly due to the negative translation impact of the stronger Canadian dollar, that was partly offset by the impact of a higher fuel surcharge and freight rate increases. 20 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Coal Year ended December 31, 2010 2009 % Change % Change at constant currency Revenues (millions) $ 600 $ 464 29% RTMs (millions) 19,766 14,805 34% Revenue/RTM (cents) 3.04 3.13 (3%) 35% 34% 1% For the year ended December 31, 2010, revenues for this com- modity group increased by $136 million, or 29%, when com- pared to 2009. The increase was mainly due to strong volumes of Canadian export coal from new origins as well as increased Asian demand from existing mines, expanding demand for thermal coal in the U.S., freight rate increases, and the impact of a higher fuel were partly offset by the negative translation impact of the stron- ger Canadian dollar. Revenue per revenue ton mile increased by 6% in 2010, mainly due to the impact of a higher fuel surcharge and freight rate increases that were partly offset by the negative translation impact of the stronger Canadian dollar. Automotive Year ended December 31, 2010 2009 % Change % Change at constant currency Revenues (millions) $ 457 $ 355 29% RTMs (millions) 2,545 2,070 23% Revenue/RTM (cents) 17.96 17.15 5% 39% 23% 13% surcharge. These factors were partly offset by the negative transla- For the year ended December 31, 2010, revenues for this com- tion impact of the stronger Canadian dollar. Revenue per revenue modity group increased by $102 million, or 29%, when com- ton mile decreased by 3% in 2010, mainly due to the negative pared to 2009. The increase was mainly due to significantly translation impact of the stronger Canadian dollar and a signifi- higher volumes of domestic finished vehicles traffic, freight rate cant increase in the average length of haul that were partly offset increases, and the impact of a higher fuel surcharge. These fac- by freight rate increases and the impact of a higher fuel surcharge. tors were partly offset by the negative translation impact of the Grain and fertilizers Year ended December 31, 2010 2009 % Change % Change at constant currency stronger Canadian dollar. Revenue per revenue ton mile increased by 5% in 2010, mainly due to freight rate increases, the impact of a higher fuel surcharge, and a significant decrease in the aver- age length of haul that were partly offset by the negative transla- tion impact of the stronger Canadian dollar. Revenues (millions) $ 1,418 $ 1,341 RTMs (millions) 44,549 40,859 Revenue/RTM (cents) 3.18 3.28 6% 9% (3%) 11% 9% 2% Other revenues For the year ended December 31, 2010, revenues for this commod- ity group increased by $77 million, or 6%, when compared to 2009. The increase was mainly due to higher shipments of potash and feed Year ended December 31, 2010 2009 % Change % Change at constant currency Revenues (millions) $ 880 $ 735 20% 26% grains, the impact of a higher fuel surcharge, and freight rate increas- In 2010, Other revenues amounted to $880 million, an increase es. These factors were partly offset by the negative translation impact of $145 million, or 20%, when compared to 2009, mainly due to of the stronger Canadian dollar. Revenue per revenue ton mile de- higher vessel and dock revenues primarily related to strong iron creased by 3% in 2010, mainly due to the negative translation impact ore volumes, and increased revenues from warehousing and dis- of the stronger Canadian dollar that was partly offset by the impact tribution, primarily related to increased finished vehicle volumes of a higher fuel surcharge and freight rate increases. through CN’s network of vehicle distribution facilities. These fac- tors were partly offset by the negative translation impact of the Intermodal stronger Canadian dollar. Year ended December 31, 2010 2009 % Change % Change at constant currency Revenues (millions) $ 1,576 $ 1,337 18% RTMs (millions) 35,803 32,159 11% Revenue/RTM (cents) 4.40 4.16 6% 20% 11% 8% For the year ended December 31, 2010, revenues for this com- modity group increased by $239 million, or 18%, when compared to 2009. The increase was mainly due to higher volumes from overseas markets, particularly through the Ports of Vancouver and Prince Rupert, and domestic retail shipments; the impact of a higher fuel surcharge; and freight rate increases. These factors Canadian National Railway Company U.S. GAAP 2011 Annual Report 21 Management’s Discussion and Analysis Operating expenses Operating expenses for the year ended December 31, 2010 amounted to $5,273 million, compared to $4,961 million in 2009. The increase of $312 million, or 6%, in 2010 was mainly due to higher fuel costs, increased labor and fringe benefits expense and higher depreciation and amortization expense. These factors were partly offset by the positive translation impact of the stronger Canadian dollar on US dollar- denominated expenses, particularly in the first half of the year, the impact of EJ&E acquisition-related costs recorded in 2009 and lower equipment rents. In millions Year ended December 31, 2010 2009 % Change Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses $ 1,744 $ 1,696 1,036 1,048 834 243 368 1,027 820 790 284 344 $ 5,273 $ 4,961 (3%) (1%) (28%) (6%) 14% (7%) (6%) % Change at constant currency Percentage of revenues 2010 2009 (7%) (6%) 21.0% 23.0% 12.5% 13.9% (40%) 12.6% 11.1% (8%) 10.1% 10.7% 7% (13%) 2.9% 4.5% 3.9% 4.7% (12%) 63.6% 67.3% Labor and fringe benefits: Labor and fringe benefits expense in- Depreciation and amortization: Depreciation and amortization creased by $48 million, or 3%, in 2010 when compared to 2009. expense increased by $44 million, or 6%, in 2010 when com- The increase was mainly due to higher incentive compensation pared to 2009. The increase was mainly due to the impact of and annual wages, the impact of increased freight volumes, and net capital additions and a change in the expected service life for higher health and welfare costs. These factors were partly offset certain assets, which were partly offset by the translation impact by the translation impact of the stronger Canadian dollar and of the stronger Canadian dollar. higher pension income. Purchased services and material: Purchased services and material lion, or 14%, in 2010 when compared to 2009. The decrease was expense increased by $9 million, or 1%, in 2010 when compared primarily due to the translation impact of the stronger Canadian to 2009. The increase was mainly a result of higher expenses for dollar and reduced lease expense for cars and locomotives, partly Equipment rents: Equipment rents expense decreased by $41 mil- third-party non-rail transportation services due to higher volumes due to better asset utilization. and higher repair and maintenance costs for track and roadway. These factors were partly offset by the translation impact of the Casualty and other: Casualty and other expense increased stronger Canadian dollar and lower expenses for material and by $24 million, or 7%, in 2010 when compared to 2009. The utilities as a result of mild winter conditions. increase was mainly due to an increase in the expense for Canadian and U.S. personal injury claims, pursuant to the net Fuel: Fuel expense increased by $228 million, or 28%, in 2010 result of actuarial valuations in both years and an increase in the when compared to 2009. The increase was primarily due to a environmental expense. These factors were partly offset by the higher average price for fuel and higher freight volumes, which EJ&E acquisition-related costs of $49 million expensed in 2009 were partly offset by the translation impact of the stronger and the translation impact of the stronger Canadian dollar. Canadian dollar and productivity improvements. 22 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Other Income tax expense: The Company recorded income tax expense Interest expense: Interest expense decreased by $52 mil- of $772 million for the year ended December 31, 2010 compared lion, or 13% (4% at constant currency), for the year ended to $407 million in 2009. Included in income tax expense in 2009 December 31, 2010 when compared to 2009, mainly due to the was a deferred income tax recovery of $157 million, of which positive translation impact of the stronger Canadian dollar on $126 million resulted from the enactment of lower provincial cor- US dollar-denominated interest expense, lower interest rates and porate income tax rates, $16 million resulted from the recapital- a lower average debt balance. ization of a foreign investment, and $15 million resulted from the resolution of various income tax matters and adjustments related Other income: In 2010, the Company recorded Other income to tax filings of prior years. The effective tax rate for 2010 was of $212 million, compared to $267 million in 2009. Included in 26.8% compared to 18.0% in 2009. Excluding the 2009 deferred Other income were gains on the sale of the Company’s subdivi- income tax recovery discussed herein, the effective tax rate for sions of $152 million for the Oakville subdivision in 2010; and 2009 was 24.9%. The year-over-year increase in the effective tax $157 million and $69 million, respectively, for the Weston and rates was mainly due to the impact of a higher proportion of the Lower Newmarket subdivisions in 2009. Higher income from Company’s pre-tax income earned in higher-taxed jurisdictions other business activities and gains on disposal of land also partly and lesser gains on sale of the Company’s properties taxed at the offset the decrease in 2010. favorable capital gains inclusion rate. Summary of fourth quarter 2011 compared to corresponding quarter in 2010 - unaudited Fourth quarter 2011 net income was $592 million, an increase of $89 million, or 18%, when compared to the same period in 2010, with diluted earnings per share rising 22% to $1.32. The fourth-quarter 2011 figures include items affecting the comparability of the results of operations. The 2011 figures include a cur- rent income tax recovery of $11 million ($0.02 per basic or diluted share) relating to certain fuel costs attributed to various wholly-owned subsidiaries’ fuel consumption in prior periods. Foreign exchange fluctuations continued to have an impact on the comparability of the results of operations. The fluctuation of the Canadian dollar relative to the US dollar, which affects the conversion of the Company’s US dollar-denominated revenues and expenses, has resulted in a positive impact of $2 million (nil per basic or diluted share) to fourth-quarter 2011 net income. Revenues for the fourth quarter of 2011 increased by $260 million, or 12%, to $2,377 million, when compared to the same period in 2010. The increase was attributable to higher freight volumes, due in part to modest improvements in North American and global econo- mies and to the Company’s performance above market conditions in a number of segments; the impact of a higher fuel surcharge, in the range of $80 million, as a result of year-over-year increases in applicable fuel prices and higher volumes; freight rate increases; and the posi- tive translation impact of the weaker Canadian dollar on US dollar-denominated revenues. Operating expenses for the fourth quarter of 2011 increased by $195 million, or 15%, to $1,538 million, when compared to the same period in 2010. The increase was primarily due to higher fuel costs, labor and fringe benefits expense as well as increased expenses for pur- chased services and material. These factors were partly offset by lower casualty and other expense. The operating ratio was 64.7% in the fourth quarter of 2011 compared to 63.4% in the fourth quarter of 2010, a 1.3-point increase. Canadian National Railway Company U.S. GAAP 2011 Annual Report 23 Management’s Discussion and Analysis Summary of quarterly financial data - unaudited In millions, except per share data 2011 Quarters 2010 Quarters Fourth Third Second First Fourth Third Second First Revenues Operating income Net income $ 2,377 $ 2,307 $ 2,260 $ 2,084 $ 2,117 $ 2,122 $ 2,093 $ 1,965 $ 839 $ 938 $ 874 $ 645 $ 774 $ 834 $ 813 $ 603 $ 592 $ 659 $ 538 $ 668 $ 503 $ 556 $ 534 $ 511 Basic earnings per share $ 1.33 $ 1.47 $ 1.19 $ 1.46 $ 1.09 $ 1.20 $ 1.14 $ 1.08 Diluted earnings per share $ 1.32 $ 1.46 $ 1.18 $ 1.45 $ 1.08 $ 1.19 $ 1.13 $ 1.08 Dividend declared per share $ 0.325 $ 0.325 $ 0.325 $ 0.325 $ 0.270 $ 0.270 $ 0.270 $ 0.270 Revenues generated by the Company during the year are influenced by seasonal weather conditions, general economic conditions, cyclical demand for rail transportation, and competitive forces in the transportation marketplace (see the section of this MD&A entitled Business risks). Operating expenses reflect the impact of freight volumes, seasonal weather conditions, labor costs, fuel prices, and the Company’s productiv- ity initiatives. The continued fluctuations in the Canadian dollar relative to the US dollar have also affected the conversion of the Company’s US dollar-denominated revenues and expenses and resulted in fluctuations in net income in the rolling eight quarters presented above. The Company’s quarterly results include items that impacted the quarter-over-quarter comparability of the results of operations as discussed below: In millions, except per share data 2011 Quarters 2010 Quarters Fourth Third Second First Fourth Third Second First Income tax recoveries (expenses) (1) $ 11 $ - $ (40) $ - $ - $ - $ - $ - Gain on disposal of property (after-tax) (2) (3) (4) - 38 - 254 - - - 131 Impact on net income $ 11 $ 38 $ (40) $ 254 $ - $ - $ - $ 131 Basic earnings per share $ 0.02 $ 0.08 $ (0.08) $ 0.55 $ - $ - $ - $ 0.28 Diluted earnings per share $ 0.02 $ 0.08 $ (0.08) $ 0.55 $ - $ - $ - $ 0.28 (1) Income tax recoveries (expenses) resulted mainly from the enactment of state corporate income tax rate changes and other legislated tax revisions in the U.S. and certain fuel costs attributed to various wholly-owned subsidiaries’ fuel consumption in prior periods. (2) The Company sold substantially all of the assets of ICRMT for proceeds of $70 million. A gain on disposal of $60 million ($38 million after-tax) was recognized in Other income. (3) The Company sold a segment of the Company’s Kingston subdivision known as the Lakeshore East of $299 million. A gain on disposal of $288 million ($254 million after-tax) was recognized in Other income. (4) The Company sold a portion of the property known as the Oakville subdivision of $168 million. A gain on disposal of $152 million ($131 million after-tax) was recognized in Other income. 24 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Financial position The following tables provide an analysis of the Company’s balance sheet as at December 31, 2011 as compared to 2010. Assets and li- abilities denominated in US dollars have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. As at December 31, 2011 and 2010, the foreign exchange rate was $1.0170 per US$1.00 and $0.9946 per US$1.00, respectively. In millions As at December 31, 2011 2010 Variance excluding foreign exchange Foreign exchange impact Explanation of variance, other than foreign exchange impact Total assets $ 26,026 $ 25,206 $ 569 $ 251 Variance mainly due to: Restricted cash and cash equivalents $ 499 $ - $ 499 $ - Accounts receivable $ 820 $ 775 $ 39 $ 6 Deferred and receivable income taxes $ 122 $ 53 $ 68 $ 1 Properties $ 23,917 $ 22,917 $ 779 $ 221 Intangible and other assets $ 261 $ 699 $ (441) $ 3 Total liabilities $ 15,346 $ 13,922 $ 1,184 $ 240 Variance mainly due to: Accounts payable and other $ 1,580 $ 1,366 $ 193 $ 21 Deferred income taxes $ 5,333 $ 5,152 $ 110 $ 71 Pension and other postretirement benefits, net of current portion $ 1,095 $ 510 $ 581 $ 4 Other liabilities and deferred credits $ 762 $ 823 $ (72) $ 11 Total long-term debt, including $ 6,576 $ 6,071 $ 372 $ 133 the current portion $499 million pledged as collateral related to letters of credit issued. $39 million increase due to the impact of higher rev- enues partially offset by the impact of an improved collection cycle. $76 million increase related to income taxes receiv- able offset by $8 million for other items. $1,712 million increase related to property and capi- tal lease additions, offset by $883 million of deprecia- tion and $50 million for other items. Decrease of $995 million related to the recognition of the funded status of the Company’s pension plans, off- set by pension contributions of $437 million, pension income of $116 million and $1 million of other items. $193 million related to an increase in Trade payables of $63 million, Stock-based incentives liability of $46 million, Payroll-related accruals of $45 million, and $39 million for other items. Increase due to $522 million of deferred income tax expense recorded in net income, excluding recog- nized tax benefits, and $9 million for other items; offset by a deferred income tax recovery of $421 mil- lion recorded in Other comprehensive income (loss). Increase of $577 million related to the recognition of the funded status of the Company’s pension plans and $4 million for other items. $72 million related to a decrease of $39 million in the personal injury and other claims provision, of $27 mil- lion in the environmental liability, and of $6 million for other items. Increase of $1,453 million related to debt issuances and $2 million for other items, offset by repayments of debt totaling $1,083 million. In millions As at December 31, 2011 2010 Variance Explanation of variance Total shareholders’ equity $ 10,680 $ 11,284 $ (604) Variance mainly due to: Common shares Accumulated other comprehensive loss $ 4,141 $ 4,252 $ (111) $ (2,839) $ (1,709) $ (1,130) Retained earnings $ 9,378 $ 8,741 $ 637 Decrease of $185 million due to the share repurchase programs, offset by $74 million for the issuance of com- mon shares upon exercise of stock options and other. $1,130 million related to Other comprehensive loss for the year, mainly due to an after-tax amount of $1,156 million recorded to recognize the funded sta- tus of the Company’s pension and other postretire- ment benefit plans. $2,457 million of net income for the year was par- tially offset by a reduction of $1,235 million due to the share repurchase programs and $585 million of dividends paid. Canadian National Railway Company U.S. GAAP 2011 Annual Report 25 Management’s Discussion and Analysis Liquidity and capital resources The Company’s principal source of liquidity is cash generated from operations and is supplemented by borrowings in the money markets and capital markets. In addition, from time to time, the Company’s liquidity requirements can be supplemented by the disposal of surplus proper- ties and the monetization of assets. The strong focus on cash generation from all sources gives the Company increased flexibility in terms of its financing requirements. As part of its financing strategy, the Company regularly reviews its optimal capital structure, cost of capital, and the need for additional debt financing, and considers from time to time the feasibility of dividend increases and share repurchases. The Company entered into a four-year $800 million revolving credit facility in May 2011 to replace the US$1 billion credit facility, which was scheduled to expire in October 2011. To meet short-term liquidity needs, the Company has a commercial paper program, which is backstopped by its revolving credit facility. Access to commercial paper is dependent on market conditions. If the Company were to lose ac- cess to its commercial paper program for an extended period of time, the Company could rely on its $800 million revolving credit facility to meet its short-term liquidity needs. See the section of this MD&A entitled Available financing arrangements for additional information. The Company has at times had working capital deficits which are considered common in the rail industry because it is capital-intensive, and not an indication of a lack of liquidity. The Company maintains adequate resources to meet daily cash requirements, and has sufficient financial capacity to manage its day-to-day cash requirements and current obligations. As at December 31, 2011 and December 31, 2010, the Company had cash and cash equivalents of $101 million and $490 million, respectively, and a working capital of $133 million and working capital deficit of $316 million, respectively. As at December 31, 2011, the Company has pledged as collateral, for a term of three months, cash and cash equivalents of $499 million pursuant to its bilateral letter of credit facilities. The cash and cash equivalents pledged as collateral were recorded as Restricted cash and cash equivalents. See the section of this MD&A entitled Available financing arrangements for additional information. There are currently no specific requirements relating to working capital other than in the normal course of business as discussed herein. The Company’s access to long-term funds in the debt capital markets depends on its credit rating and market conditions. The Company believes that it continues to have access to the long-term debt capital market. If the Company were unable to borrow funds at acceptable rates in the long-term debt capital markets, the Company could borrow under its revolving credit facility, raise cash by disposing of surplus properties or otherwise monetizing assets, reduce discretionary spending or take a combination of these measures to assure that it has ad- equate funding for its business. The Company’s U.S. and other foreign subsidiaries hold cash to meet their respective operational requirements. The Company can de- cide to repatriate funds associated with either undistributed earnings or the liquidation of its foreign operations, including its U.S. and other foreign subsidiaries. Such repatriation of funds would not cause significant tax implications to the Company under the tax treaties currently in effect between Canada and the U.S. and other foreign tax jurisdictions. Therefore, the impact on liquidity resulting from the repatriation of funds held outside Canada would not be significant. Considering the impacts of the current economic environment, the Company does not have any immediate plans to repatriate funds held outside Canada as the cash flows currently generated within each of the Company’s jurisdictions are sufficient to meet their respective financial obligations. Operating activities In millions Net cash receipts from customers and other Net cash payments for: Employee services, suppliers and other expenses Interest Personal injury and other claims Pensions Income taxes Year ended December 31, 2011 2010 Variance $ 8,995 $ 8,404 $ 591 (4,643) (4,334) (329) (97) (468) (482) (366) (64) (427) (214) (309) 37 (33) (41) (268) Net cash provided by operating activities $ 2,976 $ 2,999 $ (23) Net cash receipts from customers and other increased mainly due to higher revenues and a shorter collection cycle. Payments for employee services, suppliers and other expenses increased principally due to higher payments for fuel that were partly offset by a lower foreign ex- change rate on US dollar-denominated payments. In anticipation of its future funding requirements, in 2011 the Company made voluntary contributions of $350 million in excess of the required contributions mainly to strengthen the financial position of its main pension plan, the CN Pension Plan. The Company has been advised by the Office of the Superintendent of Financial Institutions (OSFI) that this contribu- tion can be treated as a prepayment against its 2012 pension deficit funding requirements. As a result, the Company’s cash contributions 26 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis for 2012 are expected to be in the range of approximately $275 million to $575 million for all its pension plans and include a voluntary contribution of approximately $150 million to $450 million. As at February 3, 2012, the Company contributed $250 million to its defined benefit pension plans, including a $150 million voluntary contribution. For 2011, net income tax payments increased by $268 million when compared to 2010, mainly due to installments based on higher pretax income as well as the final payment for Canadian taxes due in relation to the 2010 fiscal year. In 2012, net income tax payments are expected to be approximately $500 million. The Company expects cash from operations and its other sources of financing to be sufficient to meet its 2012 funding obligations. Investing activities In millions Year ended December 31, 2011 2010 Variance Net cash used in investing activities $ 1,729 $ 1,383 $ (346) The Company’s investing activities in 2011 included property additions of $1,625 million, an increase of $39 million when compared to 2010, and cash proceeds of $369 million from the disposal of property of which $70 million was from the disposition of substantially all of the assets of ICRMT and $299 million was from the disposition of a segment of the Company’s Kingston subdivision known as the Lakeshore East. Investing activities also included restricted cash and cash equivalents of $499 million related to the Company’s bilateral let- ter of credit facilities. Investing activities in 2010 included cash proceeds of $168 million from the disposition of a portion of the property known as the Oakville subdivision. See the sections of this MD&A entitled Acquisition and Disposal of property. The following table details property additions for the years Expenditures relating to the Company’s properties that do not meet the Company’s capitalization criteria are considered normal repairs and maintenance and are expensed. In 2011, approxi- mately 20% of the Company’s total operating expenses were for such expenditures (approximately 20% in 2010 and 2009). For Track and roadway properties, normal repairs and maintenance include but are not limited to spot tie replacement, spot or bro- ken rail replacement, physical track inspection for detection of rail defects and minor track corrections, and other general mainte- nance of track structure. For 2012, the Company expects to invest approximately $1.75 billion for its capital programs, of which over $1 billion is targeted towards track infrastructure to continue to operate a safe rail- way and to improve the productivity and fluidity of the network. Implementation costs associated with the U.S. federal govern- ment legislative requirement to implement positive train control (PTC) by 2015 will amount to approximately US$220 million, of which approximately US$30 million has been spent at the end of 2011, with the remainder to be spent over the next four years. ended December 31, 2011 and 2010: In millions Year ended December 31, 2011 2010 Track and roadway Rolling stock Buildings Information technology Other Gross property additions Less: Capital leases (1) Property additions $ 1,185 $ 1,031 195 72 135 125 415 43 111 118 1,712 1,718 87 132 $ 1,625 $ 1,586 (1) During 2011, the Company recorded $87 million in assets it acquired through equipment leases ($132 million in 2010), for which an equivalent amount was recorded in debt. On an ongoing basis, the Company invests in capital expen- diture programs for the renewal of the basic track infrastructure, the acquisition of rolling stock and other investments to take ad- vantage of growth opportunities and to improve the Company’s productivity and the fluidity of its network. Expenditures are generally capitalized if they meet a minimum level of activity, extend the life of the asset or provide future bene- fits such as increased revenue-generating capacity, functionality, or physical or service capacity. For Track and roadway properties, ex- penditures to replace and/or upgrade the basic track infrastructure are generally planned and programmed in advance and carried out by the Company’s engineering work force. In both 2011 and 2010, approximately 90% of the Track and roadway capital expenditures were incurred to renew the basic track infrastructure. Canadian National Railway Company U.S. GAAP 2011 Annual Report 27 Management’s Discussion and Analysis Free cash flow Cash received from stock options exercised during 2011 and The Company generated $1,175 million of free cash flow for the 2010 was $68 million and $87 million, respectively, and the relat- year ended December 31, 2011, compared to $1,122 million in ed tax benefit realized upon exercise was $9 million and $28 mil- 2010. Free cash flow does not have any standardized meaning pre- lion, respectively. scribed by GAAP and may, therefore, not be comparable to similar In 2011, the Company repurchased a total of 19.9 million measures presented by other companies. The Company believes that common shares for $1,420 million (weighted-average price of free cash flow is a useful measure of performance as it demonstrates $71.33 per share) under its share repurchase programs. See the the Company’s ability to generate cash after the payment of capi- section of this MD&A entitled Common shares for the activity tal expenditures and dividends. The Company defines free cash flow under the 2011 share repurchase programs, as well as the share as net cash provided by operating activities, adjusted for changes in repurchase programs of the prior years. the accounts receivable securitization program and in cash and cash During 2011, the Company paid quarterly dividends of equivalents resulting from foreign exchange fluctuations, less net $0.325 per share amounting to $585 million, compared to cash used in investing activities, adjusted for the impact of major ac- $503 million, at the rate of $0.270 per share, in 2010. quisitions, and the payment of dividends, calculated as follows: In millions Year ended December 31, 2011 2010 Net cash provided by operating activities $ 2,976 $ 2,999 Net cash used in investing activities (1,729) (1,383) Net cash provided before financing activities 1,247 1,616 Adjustments: Dividends paid (585) (503) Change in restricted cash and cash equivalents 499 Effect of foreign exchange fluctuations on US dollar-denominated cash and cash equivalents Change in accounts receivable securitization 14 - - 7 2 Credit measures Management believes that the adjusted debt-to-total capitaliza- tion ratio is a useful credit measure that aims to show the true leverage of the Company. Similarly, the adjusted debt-to-adjusted earnings before interest, income taxes, depreciation and amorti- zation (EBITDA) ratio is another useful credit measure because it reflects the Company’s ability to service its debt. The Company excludes Other income in the calculation of EBITDA. However, since these measures do not have any standardized meaning pre- scribed by GAAP, they may not be comparable to similar mea- Free cash flow $ 1,175 $ 1,122 sures presented by other companies and, as such, should not be Financing activities considered in isolation. Adjusted debt-to-total capitalization ratio In millions Year ended December 31, 2011 2010 Variance December 31, 2011 2010 Net cash used in financing activities $ 1,650 $ 1,485 $ (165) Debt-to-total capitalization ratio (1) 38.1% 35.0% In 2011, the Company issued $659 million of commercial pa- per. There was no issuance of commercial paper in 2010. In Add: Present value of operating lease commitments (2) 1.9% 1.8% Adjusted debt-to-total capitalization ratio 40.0% 36.8% 2011, repayments of debt totaling $1,083 million related to the Adjusted debt-to-adjusted EBITDA Company’s repayment of notes, commercial paper and capital lease obligations. In the fourth quarter of 2011, the Company, through a wholly-owned subsidiary, repurchased 76% of the 6.38% Notes due in October 2011, with a carrying value of US$303 million pursuant to a tender offer for a total cost of US$304 million. The remaining 24% of the 6.38% Notes with $ in millions, unless otherwise indicated Year ended December 31, 2011 2010 Debt $ 6,576 $ 6,071 Add: Present value of operating lease commitments (2) 542 494 Adjusted debt a carrying value of US$97 million were paid upon maturity. In Operating income November 2011, under its new shelf prospectus and registra- Add: Depreciation and amortization tion statement, the Company issued US$300 million (C$305 mil- EBITDA (excluding Other income) lion) 1.45% Notes due 2016 and US$400 million (C$407 mil- Add: Deemed interest on operating leases 30 28 lion) 2.85% Notes due 2021 in the U.S. capital markets, which Adjusted EBITDA $ 4,210 $ 3,886 resulted in net proceeds of US$691 million. The Company used Adjusted debt-to-adjusted EBITDA 1.69 times 1.69 times a portion of the net proceeds to repay all of its then outstanding commercial paper and for general corporate purposes, including the partial financing of its share repurchase program. In 2010, re- payments of debt related entirely to the Company’s capital lease obligations. (1) Debt-to-total capitalization is calculated as total long-term debt plus current portion of long-term debt, divided by the sum of total debt plus total shareholders’ equity. (2) The operating lease commitments have been discounted using the Company’s implicit interest rate for each of the periods presented. 28 2011 Annual Report U.S. GAAP Canadian National Railway Company 7,118 6,565 3,296 3,024 884 834 4,180 3,858 Management’s Discussion and Analysis The increase in the Company’s adjusted debt-to-total capital- Bilateral letter of credit facilities ization ratio at December 31, 2011, as compared to 2010 was In April 2011, the Company entered into a series of three-year mainly due to net debt issuances as well as a weaker Canadian- bilateral letter of credit facility agreements with various banks to-US dollar foreign exchange rate in effect at the balance sheet to support its requirements to post letters of credit in the ordi- date. The operating income earned during 2011 offset the nary course of business. As at December 31, 2011, from a to- impact of the increased debt level as at December 31, 2011, tal committed amount of $520 million by the various banks, the resulting in a flat adjusted debt-to-adjusted EBITDA multiple, as Company had letters of credit drawn of $499 million ($436 mil- compared to 2010. Available financing arrangements Revolving credit facility lion as at December 31, 2010, under its previous US$1 billion credit facility). Under these agreements, the Company has the option from time to time to pledge collateral in the form of cash or cash equivalents, for a minimum term of three months, equal to at least the face value of the letters of credit issued. As at In May 2011, the Company entered into an $800 million four-year December 31, 2011, cash and cash equivalents of $499 million revolving credit facility agreement with a consortium of lenders. were pledged as collateral and recorded as Restricted cash and The agreement allows for an increase in amount, up to a maxi- cash equivalents. mum of $500 million, as well as the option to extend the term by an additional year at each anniversary date, subject to the con- Shelf prospectus sent of individual lenders. The Company plans to use the credit In November 2011, the Company filed a new shelf prospectus facility for working capital and general corporate purposes includ- with Canadian securities regulators and a registration statement ing backstopping its commercial paper program. This facility, con- with the United States Securities and Exchange Commission taining customary terms and conditions, replaces the US$1 billion (SEC), providing for the issuance by CN of up to $2.5 billion of credit facility that was scheduled to expire in October 2011. The debt securities in Canadian and U.S. markets. The shelf prospec- credit facility agreement has one financial covenant, which lim- tus expires December 2013. Access to capital markets under the its debt as a percentage of total capitalization, and with which shelf is dependent on market conditions at the time of pricing. the Company is in compliance. As at December 31, 2011, the Company had no outstanding borrowings under its revolving All forward-looking information provided in this section is sub- credit facility (nil as at December 31, 2010). ject to risks and uncertainties and is based on assumptions about Commercial paper events and developments that may not materialize or that may be offset entirely or partially by other events and developments. The Company has a commercial paper program, which is backed See the section of this MD&A entitled Forward-looking state- by its revolving credit facility, enabling it to issue commercial pa- ments for a discussion of assumptions and risk factors affecting per up to a maximum aggregate principal amount of $800 mil- such forward-looking statements. lion, or the US dollar equivalent. As at December 31, 2011, the Company had borrowings of $82 million (US$81 million) of com- mercial paper (nil as at December 31, 2010) which were present- ed in Current portion of long-term debt on the Balance Sheet. Canadian National Railway Company U.S. GAAP 2011 Annual Report 29 Management’s Discussion and Analysis Contractual obligations In the normal course of business, the Company incurs contractual obligations. The following table sets forth the Company’s contractual obligations for the following items as at December 31, 2011: In millions Debt obligations (1) Interest on debt obligations Capital lease obligations (2) Operating lease obligations (3) Purchase obligations (4) Pension contributions (5) Other long-term liabilities reflected on the balance sheet (6) Other commitments (7) Total obligations Total 2012 2013 2014 2015 2016 thereafter $ 5,621 $ 82 $ 404 $ 328 $ - $ 557 $ 4,250 2017 & 5,025 1,254 665 727 1,065 838 323 312 99 128 457 - 77 96 301 151 103 126 225 64 40 284 270 76 101 280 46 57 276 109 61 43 280 42 85 268 297 45 - 280 39 45 3,584 328 252 - - 570 - $ 15,518 $ 1,251 $ 1,414 $ 1,442 $ 896 $ 1,531 $ 8,984 (1) Presented net of unamortized discounts, of which $834 million relates to non-interest bearing Notes due in 2094, and excludes capital lease obligations of $955 million which are included in “Capital lease obligations.” (2) Includes $955 million of minimum lease payments and $299 million of imputed interest at rates ranging from approximately 0.7% to 11.8%. (3) Includes minimum rental payments for operating leases having initial non-cancelable lease terms of one year or more. The Company also has operating lease agreements for its automotive fleet with one-year non-cancelable terms for which its practice is to renew monthly thereafter. The estimated annual rental payments for such leases are approximately $30 million and generally extend over five years. (4) Includes commitments for railroad ties, rail, freight cars, locomotives and other equipment and services, and outstanding information technology service contracts and licenses. (5) The Company’s funding requirements are determined upon completion of actuarial valuations. The Company’s next actuarial valuations required as at December 31, 2011 will be performed in 2012. The estimated minimum required payments for pension contributions, excluding current service cost, are based on the current projected results of actuarial funding valuations on a solvency basis. Actuarial valuations are required annually and as such, future payments for pension contributions are subject to re-evaluation on an annual basis. These amounts do not include voluntary contributions in future years. (See the sections of this MD&A entitled Critical accounting policies - Pensions and other postretirement benefits as well as Other risks - Pensions). (6) Includes expected payments for workers’ compensation, workforce reductions, postretirement benefits other than pensions, net unrecognized tax benefits and environmental liabilities that have been classified as contractual settlement agreements. (7) The Company has remaining estimated commitments totaling approximately $130 million in relation to the EJ&E acquisition for railroad infrastructure improvements, grade separation projects as well as commitments under a series of agreements with individual communities and a comprehensive voluntary mitigation program established to address surrounding municipalities’ concerns. The commitment for the grade separation projects is based on estimated costs provided by the Surface Transportation Board (STB) at the time of acquisition and could be subject to adjustment. In addition, remaining implementation costs associated with the U.S. federal government legislative requirement to implement PTC by 2015 are estimated to be approximately $193 million (US$190 million). For 2012 and the foreseeable future, the Company expects cash flow from operations and from its various sources of financing to be sufficient to meet its debt repayments and future obligations, and to fund anticipated capital expenditures. See the section of this MD&A entitled Forward-looking statements for a discussion of assumptions and risk factors affecting such forward-looking statements. Acquisition 2009 The following table summarizes the consideration paid for EJ&E and the fair value of the assets acquired and liabilities On January 31, 2009, the Company acquired the principal rail assumed that were recognized at the acquisition date: lines of the EJ&E, a short-line railway that operated over 198 miles of track in and around Chicago, for a total cash consideration of US$300 million (C$373 million), paid with cash on hand. The Company accounted for the acquisition using the acquisition method of accounting pursuant to FASB ASC 805, “Business Combinations,” which the Company adopted on January 1, 2009. As such, the consolidated financial statements of the Company include the assets, liabilities and results of operations of EJ&E as of January 31, 2009, the date of acquisition. The costs incurred to acquire the EJ&E of approximately $49 million were expensed and reported in Casualty and other in the Consolidated Statement of Income for the year ended December 31, 2009 (see Note 2 - Accounting changes). In US millions Consideration Cash Fair value of total consideration transferred Recognized amounts of identifiable assets acquired and liabilities assumed Current assets Properties Current liabilities Other noncurrent liabilities Total identifiable net assets At January 31, 2009 $ 300 $ 300 $ 4 310 (4) (10) $ 300 The 2009 revenues and net income of EJ&E included in the Company’s Consolidated Statement of Income from the acquisi- tion date to December 31, 2009, were $74 million and $12 mil- lion, respectively. 30 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Disposal of property 2011 IC RailMarine Terminal subdivision in Vaughan and Toronto, Ontario, together with the rail fixtures and certain passenger agreements (collectively the “Lower Newmarket subdivision”), for cash proceeds of $71 million before In August 2011, the Company sold substantially all of the assets of IC transaction costs. Under the agreement, the Company obtained the RailMarine Terminal Company (ICRMT), an indirect subsidiary of the perpetual right to operate freight trains over the Lower Newmarket Company, to Raven Energy, LLC, an affiliate of Foresight Energy, LLC subdivision at its then current level of operating activity, with the (Foresight) and the Cline Group (Cline), for cash proceeds of $70 mil- possibility of increasing its operating activity for additional consider- lion (US$73 million) before transaction costs. ICRMT is located on the ation. The transaction resulted in a gain on disposal of $69 million east bank of the Mississippi River and stores and transfers bulk com- ($59 million after-tax) that was recorded in Other income under the modities and liquids between rail, ship and barge, serving customers full accrual method of accounting for real estate transactions. in North American and global markets. Under the sale agreement, the Company will benefit from a 10-year rail transportation agree- Weston subdivision ment with Savatran LLC, an affiliate of Foresight and Cline, to haul a In March 2009, the Company entered into an agreement with minimum annual volume of coal from four Illinois mines to the ICRMT GO Transit to sell the property known as the Weston subdivision transfer facility. The transaction resulted in a gain on disposal of in Toronto, Ontario, together with the rail fixtures and certain pas- $60 million ($38 million after-tax) that was recorded in Other income. senger agreements (collectively the “Weston subdivision”), for Lakeshore East cash proceeds of $160 million before transaction costs, of which $50 million placed in escrow at the time of disposal was entirely In March 2011, the Company entered into an agreement with released by December 31, 2009 in accordance with the terms of Metrolinx to sell a segment of the Kingston subdivision known as the agreement. Under the agreement, the Company obtained the the Lakeshore East in Pickering and Toronto, Ontario, together with perpetual right to operate freight trains over the Weston subdivi- the rail fixtures and certain passenger agreements (collectively the sion at its then current level of operating activity, with the possibil- “Lakeshore East”), for cash proceeds of $299 million before trans- ity of increasing its operating activity for additional consideration. action costs. Under the agreement, the Company obtained the The transaction resulted in a gain on disposal of $157 million perpetual right to operate freight trains over the Lakeshore East ($135 million after-tax) that was recorded in Other income under at its then current level of operating activity, with the possibility of the full accrual method of accounting for real estate transactions. increasing its operating activity for additional consideration. The transaction resulted in a gain on disposal of $288 million ($254 mil- Off balance sheet arrangements lion after-tax) that was recorded in Other income under the full ac- Accounts receivable securitization program crual method of accounting for real estate transactions. The Company had a five-year agreement to sell an undivided co- 2010 Oakville subdivision ownership interest in a revolving pool of freight receivables to an unrelated trust for maximum cash proceeds of $600 million. The agreement expired on May 31, 2011 and was not renewed. In March 2010, the Company entered into an agreement with Metrolinx to sell a portion of the property known as the Oakville Guarantees and indemnifications subdivision in Toronto, Ontario, together with the rail fixtures and In the normal course of business, the Company, including certain of certain passenger agreements (collectively the “Oakville subdivi- its subsidiaries, enters into agreements that may involve providing sion”), for proceeds of $168 million before transaction costs, of guarantees or indemnifications to third parties and others, which may which $24 million was placed in escrow at the time of disposal and extend beyond the term of the agreements. These include, but are was entirely released by December 31, 2010 in accordance with the not limited to, residual value guarantees on operating leases, standby terms of the agreement. Under the agreement, the Company ob- letters of credit and surety and other bonds, and indemnifications that tained the perpetual right to operate freight trains over the Oakville are customary for the type of transaction or for the railway business. subdivision at its then current level of operating activity, with the The Company is required to recognize a liability for the fair value possibility of increasing its operating activity for additional consider- of the obligation undertaken in issuing certain guarantees on the date ation. The transaction resulted in a gain on disposal of $152 million the guarantee is issued or modified. In addition, where the Company ($131 million after-tax) that was recorded in Other income under expects to make a payment in respect of a guarantee, a liability will be the full accrual method of accounting for real estate transactions. recognized to the extent that one has not yet been recognized. 2009 Lower Newmarket subdivision The nature of these guarantees or indemnifications, the maxi- mum potential amount of future payments, the carrying amount of the liability, if any, and the nature of any recourse provisions In November 2009, the Company entered into an agreement with are disclosed in Note 17 - Major commitments and contingencies Metrolinx to sell the property known as the Lower Newmarket to the Company’s Annual Consolidated Financial Statements. Canadian National Railway Company U.S. GAAP 2011 Annual Report 31 Management’s Discussion and Analysis Stock plans See the section of this MD&A entitled Forward-looking state- The Company has various stock-based incentive plans for eli- ments for assumptions and risk factors affecting such forward- gible employees. A description of the Company’s major plans looking statement. is provided in Note 11 - Stock plans, to the Company’s Annual Consolidated Financial Statements. The following table provides Common shares the total stock-based compensation expense for awards under all Share repurchase programs plans, as well as the related tax benefit recognized in income, for In January 2011, the Board of Directors of the Company approved the years ended December 31, 2011, 2010 and 2009: a share repurchase program which allowed for the repurchase of In millions Year ended December 31, 2011 2010 2009 Cash settled awards Restricted share unit plan $ 81 $ 77 $ 43 Voluntary Incentive Deferral Plan Stock option awards 21 102 10 18 95 9 33 76 14 Total stock-based compensation expense $ 112 $ 104 $ 90 Tax benefit recognized in income $ 24 $ 27 $ 26 Financial instruments In the normal course of business, the Company is exposed to vari- ous risks such as customer credit risk, commodity price risk, inter- est rate risk, foreign currency risk, and liquidity risk. To manage these risks, the Company follows a financial risk management up to 16.5 million common shares to the end of December 2011 pursuant to a normal course issuer bid, at prevailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock Exchange. This share repurchase program was completed by September 30, 2011. In October 2011, the Board of Directors of the Company approved a new share repurchase program which allows for the repurchase of up to 17.0 million common shares between October 28, 2011 and October 27, 2012 pursuant to a normal course issuer bid at prevailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock Exchange. The following table provides the activity under such share re- purchase programs, as well as the share repurchase programs of the prior years: framework, which is monitored and approved by the Company’s In millions, except per share data Finance Committee, with a goal of maintaining a strong balance Year ended December 31, 2011 2010 2009 sheet, optimizing earnings per share and free cash flow, financing October 2011 - October 2012 program its operations at an optimal cost of capital and preserving its liquid- Number of common shares (1) 3.4 ity. The Company has limited involvement with derivative financial Weighted-average price per share (2) $ 75.08 instruments in the management of its risks and does not use them Amount of repurchase $ 256 for trading purposes. At December 31, 2011, the Company did not have any significant derivative financial instruments outstand- ing. See Note 18 - Financial instruments, to the Company’s Annual Consolidated Financial Statements for a discussion of such risks. January 2011 - December 2011 program Number of common shares (1) 16.5 Weighted-average price per share (2) $ 70.56 Amount of repurchase $ 1,164 Payments for income taxes The Company is required to make scheduled installment pay- ments as prescribed by the tax authorities. In Canada, the Company’s domestic jurisdiction, tax installments in a given year are generally based on the prior year’s pretax income whereas in the U.S., the Company’s predominate foreign jurisdiction, they are based on forecasted pretax income of that year. In 2011, net income tax payments to Canadian tax authorities were $360 million ($171 million in 2010) and net income tax payments to U.S. tax authorities were $122 million ($43 million in 2010). For the 2012 fiscal year, the Company’s net income tax payments are expected to be approximately $500 million. Net income tax payments for 2011 and 2012 both include the impact of recent changes in tax laws, specifically, the savings attributable to the Tax Relief, Unemployment January 2010 - December 2010 program Number of common shares (1) Weighted-average price per share (2) Amount of repurchase July 2008 - July 2009 program Number of common shares Weighted-average price per share Amount of repurchase Total for the year N/A N/A N/A N/A N/A N/A Number of common shares (1) 19.9 15.0 - Weighted-average price per share (2) $ 71.33 $ 60.86 $ - Amount of repurchase $ 1,420 $ 913 $ - (1) Includes common shares purchased in the first and fourth quarters of 2011 and in the second and third quarters of 2010 pursuant to private agreements between the Company and arm’s-length third-party sellers. Insurance Reauthorization and Job Creation Act in the United States, (2) Includes brokerage fees. which increases the accelerated depreciation allowable from 50% to 100% for the period from September 2010 through to the end of 2011, and allows for 50% accelerated depreciation in 2012. 32 2011 Annual Report U.S. GAAP Canadian National Railway Company N/A N/A N/A N/A N/A N/A 15.0 $ 60.86 $ 913 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A - N/A $ - N/A $ - Management’s Discussion and Analysis Outstanding share data Canada As at February 3, 2012, the Company had 442.0 million common Employee injuries are governed by the workers’ compensation shares and 6.3 million stock options outstanding. legislation in each province whereby employees may be awarded Recent accounting pronouncement either a lump sum or future stream of payments depending on the nature and severity of the injury. As such, the provision for The Accounting Standards Board of the Canadian Institute of employee injury claims is discounted. In the provinces where the Chartered Accountants requires all publicly accountable enter- Company is self-insured, costs related to employee work-related prises to report under International Financial Reporting Standards injuries are accounted for based on actuarially developed esti- (IFRS) for the fiscal years beginning on or after January 1, mates of the ultimate cost associated with such injuries, including 2011. However, National Instrument 52-107 issued by the compensation, health care and third-party administration costs. A Ontario Securities Commission allows Securities and Exchange comprehensive actuarial study is generally performed at least on a Commission (SEC) issuers, as defined by the U.S. Securities and triennial basis. For all other legal actions, the Company maintains, Exchange Commission, such as CN, to file with Canadian securi- and regularly updates on a case-by-case basis, provisions for such ties regulators financial statements prepared in accordance with items when the expected loss is both probable and can be rea- U.S. GAAP. As such, the Company has decided not to report sonably estimated based on currently available information. under IFRS by 2011 and to continue reporting under U.S. GAAP. As at December 31, 2011, 2010 and 2009, the Company’s The SEC has issued a roadmap for the potential convergence to provision for personal injury and other claims in Canada was as IFRS for U.S. issuers. Should the SEC decide it will move forward follows: with the convergence to IFRS, the Company will convert its reporting to IFRS at that time. Critical accounting policies The preparation of financial statements in conformity with gener- ally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of revenues and expenses during the period, the reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements. On an on- going basis, management reviews its estimates based upon cur- rently available information. Actual results could differ from these estimates. The Company’s policies for personal injury and other claims, environmental matters, depreciation, pensions and other postretirement benefits, and income taxes, require management’s more significant judgments and estimates in the preparation of the Company’s consolidated financial statements and, as such, are considered to be critical. The following information should be read in conjunction with the Company’s Annual Consolidated Financial Statements and Notes thereto. Management discusses the development and selection of the Company’s critical accounting estimates with the Audit Committee of the Company’s Board of Directors, and the Audit Committee has reviewed the Company’s related disclosures. Personal injury and other claims In the normal course of business, the Company becomes involved in various legal actions seeking compensatory and occasionally punitive damages, including actions brought on behalf of various purported classes of claimants and claims relating to employee and third-party personal injuries, occupational disease and prop- erty damage, arising out of harm to individuals or property alleg- edly caused by, but not limited to, derailments or other accidents. In millions 2011 2010 2009 Balance January 1 $ 200 $ 178 $ 189 Accruals and other Payments 31 (32) 59 (37) 48 (59) Balance December 31 $ 199 $ 200 $ 178 Current portion - Balance December 31 $ 39 $ 39 $ 34 Assumptions used in estimating the ultimate costs for Canadian employee injury claims consider, among others, the discount rate, the rate of inflation, wage increases and health care costs. The Company periodically reviews its assumptions to reflect currently available information. Over the past three years, the Company has not significantly changed any of these assump- tions. Changes in any of these assumptions could materially affect Casualty and other expense as reported in the Company’s results of operations. For all other legal claims in Canada, estimates are based on the specifics of the case, trends and judgment. United States Personal injury claims by the Company’s employees, including claims alleging occupational disease and work-related injuries, are subject to the provisions of the Federal Employers’ Liability Act (FELA). Employees are compensated under FELA for damages as- sessed based on a finding of fault through the U.S. jury system or through individual settlements. As such, the provision is undis- counted. With limited exceptions where claims are evaluated on a case-by-case basis, the Company follows an actuarial-based ap- proach and accrues the expected cost for personal injury, including asserted and unasserted occupational disease claims, and property damage claims, based on actuarial estimates of their ultimate cost. A comprehensive actuarial study is performed annually. Canadian National Railway Company U.S. GAAP 2011 Annual Report 33 Management’s Discussion and Analysis For employee work-related injuries, including asserted occu- Environmental matters pational disease claims, and third-party claims, including grade Known existing environmental concerns crossing, trespasser and property damage claims, the actuarial The Company has identified approximately 310 sites at which valuation considers, among other factors, CN’s historical patterns it is or may be liable for remediation costs, in some cases along of claims filings and payments. For unasserted occupational dis- with other potentially responsible parties, associated with alleged ease claims, the actuarial study includes the projection of CN’s contamination and is subject to environmental clean-up and en- experience into the future considering the potentially exposed forcement actions, including those imposed by the United States population. The Company adjusts its liability based upon man- Federal Comprehensive Environmental Response, Compensation agement’s assessment and the results of the study. On an ongo- and Liability Act of 1980 (CERCLA), also known as the Superfund ing basis, management reviews and compares the assumptions law, or analogous state laws. CERCLA and similar state laws, in inherent in the latest actuarial study with the current claim experi- addition to other similar Canadian and U.S. laws, generally im- ence and, if required, adjustments to the liability are recorded. pose joint and several liability for clean-up and enforcement costs Due to the inherent uncertainty involved in projecting future on current and former owners and operators of a site, as well events, including events related to occupational diseases, which as those whose waste is disposed of at the site, without regard include but are not limited to, the timing and number of actual to fault or the legality of the original conduct. The Company has claims, the average cost per claim and the legislative and judi- been notified that it is a potentially responsible party for study cial environment, the Company’s future payments may differ from and clean-up costs at approximately 10 sites governed by the current amounts recorded. Superfund law (and analogous state laws) for which investigation External actuarial studies reflecting favorable claims devel- and remediation payments are or will be made or are yet to be opment over recent years have supported net reductions to the determined and, in many instances, is one of several potentially Company’s provision for U.S. personal injury and other claims of responsible parties. $6 million, $19 million and $60 million in 2011, 2010 and 2009, The ultimate cost of addressing these known contaminated respectively. The reductions were mainly attributable to decreases sites cannot be definitely established given that the estimated en- in the Company’s estimates of unasserted claims and costs re- vironmental liability for any given site may vary depending on the lated to asserted claims as a result of its ongoing risk mitigation nature and extent of the contamination; the nature of anticipated strategy focused on reducing the frequency and severity of claims response actions, taking into account the available clean-up tech- through injury prevention and containment; mitigation of claims; niques; evolving regulatory standards governing environmental and lower settlements for existing claims. liability; and the number of potentially responsible parties and As at December 31, 2011, 2010 and 2009, the Company’s their financial viability. As a result, liabilities are recorded based provision for personal injury and other claims in the U.S. was as on the results of a four-phase assessment conducted on a site- follows: In millions 2011 2010 2009 Balance January 1 $ 146 $ 166 $ 265 Accruals and other Payments 30 (65) 7 (27) (46) (53) Balance December 31 $ 111 $ 146 $ 166 by-site basis. A liability is initially recorded when environmental assessments occur, remedial efforts are probable, and when the costs, based on a specific plan of action in terms of the technol- ogy to be used and the extent of the corrective action required, can be reasonably estimated. The Company estimates the costs related to a particular site using cost scenarios established by ex- ternal consultants based on the extent of contamination and ex- Current portion - Balance December 31 $ 45 $ 44 $ 72 pected costs for remedial efforts. In the case of multiple parties, For the U.S. personal injury and other claims liability, histori- cal claim data is used to formulate assumptions relating to the expected number of claims and average cost per claim (severity) for each year. Changes in any one of these assumptions could materially affect Casualty and other expense as reported in the Company’s results of operations. For example, a 5% change in the asbestos average claim cost or a 1% change in the inflation trend rate would result in an increase or decrease of approxi- mately $2 million in the liability recorded for unasserted asbestos claims. the Company accrues its allocable share of liability taking into ac- count the Company’s alleged responsibility, the number of poten- tially responsible parties and their ability to pay their respective share of the liability. Adjustments to initial estimates are recorded as additional information becomes available. The Company’s provision for specific environmental sites is un- discounted and includes costs for remediation and restoration of sites, as well as monitoring costs. Environmental accruals, which are classified as Casualty and other in the Consolidated Statement of Income, include amounts for newly identified sites or contami- nants as well as adjustments to initial estimates. Recoveries of en- vironmental remediation costs from other parties are recorded as assets when their receipt is deemed probable. 34 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis As at December 31, 2011, 2010 and 2009, the Company’s incurred in the future, or will not have a material adverse effect provision for specific environmental sites was as follows: on the Company’s financial position or results of operations in In millions 2011 2010 2009 Balance January 1 $ 150 $ 103 $ 125 Accruals and other Payments 17 (15) 67 (20) (7) (15) Balance December 31 $ 152 $ 150 $ 103 Current portion - Balance December 31 $ 63 $ 34 $ 38 The Company anticipates that the majority of the liability at December 31, 2011 will be paid out over the next five years. However, some costs may be paid out over a longer period. The Company expects to partly recover certain accrued remediation costs associated with alleged contamination and has recorded a receivable in Intangible and other assets for such recover- able amounts. Based on the information currently available, the Company considers its provisions to be adequate. As of December 31, 2011, most of the Company’s properties have reached the final assessment stage; therefore costs related to such sites have been anticipated. The final assessment stage can span multiple years. Unknown existing environmental concerns While the Company believes that it has identified the costs likely to be incurred for environmental matters in the next several years based on known information, the discovery of new facts, future changes in laws, the possibility of releases of hazardous materi- als into the environment and the Company’s ongoing efforts to identify potential environmental liabilities that may be associated with its properties may result in the identification of additional environmental liabilities and related costs. The magnitude of such additional liabilities and the costs of complying with future en- vironmental laws and containing or remediating contamination cannot be reasonably estimated due to many factors, including: (i) the lack of specific technical information available with respect to many sites; (ii) the absence of any government authority, third-party orders, or claims with respect to particular sites; (iii) the potential for new or changed laws and regulations and for development of new remediation technologies and uncertainty regarding the timing of the work with respect to particular sites; and (iv) the determination of the Company’s liability in proportion to other potentially responsible parties and the ability to recover costs from any third parties with respect to particular sites. Therefore, the likelihood of any such costs being incurred or whether such costs would be material to the Company cannot be determined at this time. There can thus be no assurance that liabilities or costs related to environmental matters will not be a particular quarter or fiscal year, or that the Company’s liquid- ity will not be adversely impacted by such liabilities or costs, al- though management believes, based on current information, that the costs to address environmental matters will not have a mate- rial adverse effect on the Company’s financial position or liquidity. Costs related to any unknown existing or future contamination will be accrued in the period in which they become probable and reasonably estimable. Future occurrences In railroad and related transportation operations, it is possible that derailments or other accidents, including spills and releases of hazardous materials, may occur that could cause harm to hu- man health or to the environment. As a result, the Company may incur costs in the future, which may be material, to address any such harm, compliance with laws and other risks, including costs relating to the performance of clean-ups, payment of environ- mental penalties and remediation obligations, and damages relat- ing to harm to individuals or property. Regulatory compliance The Company may incur significant capital and operating costs associated with environmental regulatory compliance and clean- up requirements, in its railroad operations and relating to its past and present ownership, operation or control of real property. Environmental expenditures that relate to current operations are expensed unless they relate to an improvement to the property. Expenditures that relate to an existing condition caused by past operations and which are not expected to contribute to current or future operations are expensed. Operating expenses for envi- ronmental matters amounted to $4 million in 2011, $23 million in 2010 and $11 million in 2009. For 2012, the Company expects to incur approximately $15 million of operating expenses relat- ing to environmental matters. In addition, based on the results of its operations and maintenance programs, as well as ongo- ing environmental audits and other factors, the Company plans for specific capital improvements on an annual basis. Certain of these improvements help ensure facilities, such as fuelling sta- tions and waste water and storm water treatment systems, com- ply with environmental standards and include new construction and the updating of existing systems and/or processes. Other capital expenditures relate to assessing and remediating certain impaired properties. The Company’s environmental capital expen- ditures amounted to $11 million in 2011, $14 million in 2010 and $9 million in 2009. For 2012, the Company expects to incur capi- tal expenditures relating to environmental matters in the same range as 2011. Canadian National Railway Company U.S. GAAP 2011 Annual Report 35 Management’s Discussion and Analysis Depreciation In 2011, the Company recorded total depreciation expense of Properties are carried at cost less accumulated depreciation in- $883 million ($833 million in 2010 and $789 million in 2009). At cluding asset impairment write-downs. The cost of properties, December 31, 2011, the Company had Properties of $23,917 mil- including those under capital leases, net of asset impairment lion, net of accumulated depreciation of $9,904 million ($22,917 mil- write-downs, is depreciated on a straight-line basis over their es- lion in 2010, net of accumulated depreciation of $9,553 million). timated service lives, measured in years, except for rail which is Additional disclosures are provided in Note 5 - Properties, to the measured in millions of gross tons per mile. The Company fol- Company’s Annual Consolidated Financial Statements. lows the group method of depreciation whereby a single com- U.S. generally accepted accounting principles require the use posite depreciation rate is applied to the gross investment in a of historical cost as the basis of reporting in financial statements. class of similar assets, despite small differences in the service life As a result, the cumulative effect of inflation, which has sig- or salvage value of individual property units within the same as- nificantly increased asset replacement costs for capital-intensive set class. The Company uses approximately 40 different depre- companies such as CN, is not reflected in operating expenses. ciable asset classes. Depreciation charges on an inflation-adjusted basis, assuming For all depreciable assets, the depreciation rate is based on that all operating assets are replaced at current price levels, would the estimated service lives of the assets. Assessing the reason- be substantially greater than historically reported amounts. ableness of the estimated service lives of properties requires judgment and is based on currently available information, includ- Pensions and other postretirement benefits ing periodic depreciation studies conducted by the Company. The Company’s plans have a measurement date of December 31. The Company’s U.S. properties are subject to comprehensive The following table shows the Company’s pension asset, pension depreciation studies as required by the STB and are conducted liability and other postretirement benefits liability at December 31, by external experts. Depreciation studies for Canadian properties 2011, and December 31, 2010: are not required by regulation and are therefore conducted in- ternally. Studies are performed on specific asset groups on a pe- riodic basis. Changes in the estimated service lives of the assets and their related composite depreciation rates are implemented prospectively. The studies consider, among other factors, the analysis of historical retirement data using recognized life analysis tech- niques, and the forecasting of asset life characteristics. Changes in circumstances, such as technological advances, changes to the Company’s business strategy, changes in the Company’s capital strategy or changes in regulations can result in the actual service lives differing from the Company’s estimates. A change in the remaining service life of a group of assets, or their estimated net salvage value, will affect the depreciation rate used to amortize the group of assets and thus affect depre- ciation expense as reported in the Company’s results of opera- tions. A change of one year in the composite service life of the Company’s fixed asset base would impact annual depreciation In millions Pension asset Pension liability Other postretirement benefits liability December 31, 2011 2010 $ - $ 442 $ 829 $ 245 $ 284 $ 283 The descriptions in the following paragraphs pertaining to pensions relate generally to the Company’s main pension plan, the CN Pension Plan, unless otherwise specified. Calculation of net periodic benefit cost (income) The Company accounts for net periodic benefit cost for pensions and other postretirement benefits as required by FASB ASC 715 “Compensation - Retirement Benefits.” Under the standard, as- sumptions are made regarding the valuation of benefit obliga- tions and performance of plan assets. In the calculation of net pe- riodic benefit cost, the standard allows for a gradual recognition of changes in benefit obligations and fund performance over the expected average remaining service life of the employee group expense by approximately $23 million. covered by the plans. Depreciation studies are a means of ensuring that the as- sumptions used to estimate the service lives of particular asset groups are still valid and where they are not, they serve as the basis to establish the new depreciation rates to be used on a pro- spective basis. In the first quarter of 2011, the Company com- pleted the final phase of its depreciation studies that began in 2010 for Canadian properties and U.S. rolling stock and equip- ment. As a result of this phase of the studies, in the first quar- ter of 2011, the Company changed the estimated service lives for various assets and their related composite depreciation rates. Overall, the depreciation studies resulted in an annualized in- crease to depreciation expense of approximately $30 million. In accounting for pensions and other postretirement benefits, assumptions are required for, among others, the discount rate, the expected long-term rate of return on plan assets, the rate of compensation increase, health care cost trend rates, mortal- ity rates, employee early retirements, terminations and disability. Changes in these assumptions result in actuarial gains or losses, which are recognized in Other comprehensive income (loss). The Company amortizes these gains or losses into net periodic ben- efit cost over the expected average remaining service life of the employee group covered by the plans only to the extent that the unrecognized net actuarial gains and losses are in excess of the corridor threshold, which is calculated as 10% of the greater of 36 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis the beginning-of-year balances of the projected benefit obliga- 2011, the Company recorded a net actuarial loss of $1,543 mil- tion or market-related value of plan assets. The Company’s net lion on its pension plans increasing the net actuarial loss recog- periodic benefit cost for future periods is dependent on demo- nized in Accumulated other comprehensive loss to $2,720 mil- graphic experience, economic conditions and investment perfor- lion ($1,185 million in 2010). The increase in the net actuarial mance. Recent demographic experience has revealed no material loss was primarily due to the negative liability experience resulting net gains or losses on termination, retirement, disability and mor- from the decrease in the discount rate from 5.32% to 4.84%, as tality. Experience with respect to economic conditions and invest- well as the difference in the actual and expected return on plan ment performance is further discussed herein. assets for the year ended December 31, 2011. For the years ended December 31, 2011, 2010 and 2009, the For the year ended December 31, 2011, a 0.25% decrease in consolidated net period benefit cost (income) for pensions and the 4.84% discount rate used to determine the projected ben- other postretirement benefits were as follows: efit obligation would have resulted in a decrease of approximately In millions Year ended December 31, 2011 2010 2009 Net periodic benefit cost (income) for pensions $ (80) $ (70) $ (34) Net periodic benefit cost for other postretirement benefits $385 million to the funded status for pensions and an increase of approximately $25 million to the 2012 net periodic benefit cost. A 0.25% increase in the discount rate would have resulted in an increase of approximately $375 million to the funded status $ 19 $ 18 $ 19 for pensions and a decrease of approximately $25 million to the At December 31, 2011 and 2010, the projected pension ben- efit obligation and accumulated other postretirement benefit obli- gation (APBO) were as follows: In millions December 31, 2011 2010 2012 net periodic benefit cost. Expected long-term rate of return assumption To develop its expected long-term rate of return assumption used in the calculation of net periodic benefit cost applicable to the Projected pension benefit obligation $ 15,548 $ 14,895 market-related value of assets, the Company considers multiple Accumulated other postretirement benefit obligation $ 284 $ 283 Discount rate assumption factors. The expected long-term rate of return is determined based on expected future performance for each asset class and is weighted based on the current asset portfolio mix. Consideration is taken of the historical performance, the premium return gener- The Company’s discount rate assumption, which is set annually ated from an actively managed portfolio, as well as current and at the end of each year, is used to determine the projected ben- future anticipated asset allocations, economic developments, efit obligation at the end of the year and the net periodic benefit inflation rates and administrative expenses. Based on these fac- cost for the following year. The discount rate is used to measure tors, the rate is determined by the Company. For 2011, the the single amount that, if invested at the measurement date in a Company used a long-term rate of return assumption of 7.50% portfolio of high-quality debt instruments with a rating of AA or on the market-related value of plan assets to compute net pe- better, would provide the necessary cash flows to pay for pension riodic benefit cost. Effective January 1, 2012, the Company will benefits as they become due. The discount rate is determined by reduce the expected long-term rate of return on plan assets from management with the aid of third-party actuaries. The Company’s 7.50% to 7.25% to reflect management’s current view of long- methodology for determining the discount rate is based on a ze- term investment returns. The effect of this change in manage- ro-coupon bond yield curve, which is derived from semi-annual ment’s assumption will be to increase 2012 net periodic benefit bond yields provided by a third party. The portfolio of hypotheti- cost by approximately $20 million. The Company has elected to cal zero-coupon bonds is expected to generate cash flows that use a market-related value of assets, whereby realized and unre- match the estimated future benefit payments of the plans as the alized gains/losses and appreciation/depreciation in the value of bond rate for each maturity year is applied to the plans’ corre- the investments are recognized over a period of five years, while sponding expected benefit payments of that year. A discount rate investment income is recognized immediately. If the Company of 4.84%, based on bond yields prevailing at December 31, 2011 had elected to use the market value of assets, which for the CN (5.32% at December 31, 2010) was considered appropriate by Pension Plan at December 31, 2011 was approximately the same the Company to match the approximately 10-year average dura- as the market-related value of assets, there would be no signifi- tion of estimated future benefit payments. The current estimate cant impact to the net periodic benefit cost for 2012. for the expected average remaining service life of the employee The assets of the Company’s various plans are held in separate group covered by the plans is approximately nine years. trust funds which are diversified by asset type, country and in- The Company amortizes net actuarial gains and losses over vestment strategies. Each year, the CN Board of Directors reviews the expected average remaining service life of the employee and confirms or amends the Statement of Investment Policies and group covered by the plans, only to the extent they are in ex- Procedures (SIPP) which includes the plans’ long-term asset class cess of the corridor threshold. For the year ended December 31, mix and related benchmark indices (Policy). This Policy is based Canadian National Railway Company U.S. GAAP 2011 Annual Report 37 Management’s Discussion and Analysis on a long-term forward-looking view of the world economy, the Plan asset allocation dynamics of the plans’ benefit liabilities, the market return ex- Based on the fair value of the assets held as at December 31, pectations of each asset class and the current state of financial 2011, excluding the economic exposure of derivatives, the assets markets. The Policy mix in 2011 was: 2% cash and short-term of the Company’s various plans are comprised of 7.0% in cash investments, 38% bonds, 47% equities, 4% real estate, 5% oil and short-term investments, 26.3% in bonds, 1.2% in mortgag- and gas and 4% infrastructure assets. es, 42.3% in equities, 1.5% in real estate assets, 8.4% in oil and Annually, the CN Investment Division, a division of the gas, 4.8% in infrastructure, 8.2% in absolute return investments Company created to invest and administer the assets of the plans, and 0.3% in other assets. See Note 12 - Pensions and other proposes a short-term asset mix target (Strategy) for the com- postretirement benefits, to the Company’s Annual Consolidated ing year, which is expected to differ from the Policy, because of Financial Statements for information on the fair value measure- current economic and market conditions and expectations. The ments of such assets. Investment Committee of the Board (Committee) regularly com- A significant portion of the plans’ assets are invested in pub- pares the actual asset mix to the Policy and Strategy asset mixes licly traded equity securities whose return is primarily driven by and evaluates the actual performance of the trust funds in rela- stock market performance. Debt securities also account for a sig- tion to the performance of the Policy, calculated using Policy asset nificant portion of the plans’ investments and provide a partial mix and the performance of the benchmark indices. offset to the variation in the pension benefit obligation that is The Committee’s approval is required for all major investments driven by changes in the discount rate. The funded status of the in illiquid securities. The SIPP allows for the use of derivative fi- plan fluctuates with future market conditions and impacts fund- nancial instruments to implement strategies or to hedge or adjust ing requirements. The Company will continue to make contribu- existing or anticipated exposures. The SIPP prohibits investments tions to the pension plans that as a minimum meet pension legis- in securities of the Company or its subsidiaries. During the last lative requirements. 10 years ended December 31, 2011, the CN Pension Plan earned an annual average rate of return of 6.62%. Rate of compensation increase and health care cost trend rate The actual, market-related value, and expected rates of return The rate of compensation increase is determined by the Company on plan assets for the last five years were as follows: based upon its long-term plans for such increases. For 2011, a Rates of return 2011 2010 2009 2008 2007 Actual 0.3% 8.7% 10.8% (11.0%) 8.0% Market-related value 3.0% 4.8% 6.5% 7.8% 12.7% Expected 7.50% 7.75% 7.75% 8.00% 8.00% The Company’s expected long-term rate of return on plan as- sets reflects management’s view of long-term investment returns and the effect of a 1% variation in such rate of return would re- sult in a change to the net periodic benefit cost of approximately rate of compensation increase of 3.25% and 3.50% was used to determine the projected benefit obligation and the net periodic benefit cost respectively. For postretirement benefits other than pensions, the Company reviews external data and its own historical trends for health care costs to determine the health care cost trend rates. For measure- ment purposes, the projected health care cost trend rate for pre- scription drugs was assumed to be 10% in 2011, and it is as- sumed that the rate will decrease gradually to 4.5% in 2028 and $85 million. Management’s assumption of the expected long- remain at that level thereafter. term rate of return is subject to risks and uncertainties that could cause the actual rate of return to differ materially from manage- ment’s assumption. There can be no assurance that the plan as- sets will be able to earn the expected long-term rate of return on plan assets. For the year ended December 31, 2011, a one-percentage- point change in either the rate of compensation increase or the health care cost trend rate would not cause a material change to the Company’s net periodic benefit cost for both pensions and other postretirement benefits. Net periodic benefit cost for pensions for 2012 Funding of pension plans In 2012, the Company expects a net periodic benefit cost in the range of approximately $20 million to $35 million for all its de- fined benefit pension plans. The unfavorable variance compared to 2011 is mainly due to a decrease in the expected rate of return from 7.50% to 7.25% as well as the amortization of actuarial losses resulting from a decrease in the discount rate used from 5.32% to 4.84% and an actual return on plan assets less than the expected return in 2011, partly offset by lower interest costs. For accounting purposes, the funded status is calculated under gener- ally accepted accounting principles for all pension plans. For funding purposes, the funded status is also calculated under going-concern and solvency scenarios as prescribed under pension legislation and subject to guidance issued by the Canadian Institute of Actuaries (CIA) for all of the Canadian defined benefit pension plans. The Company’s funding requirements are determined upon completion of actuarial valuations. Due to recent legislative changes, actuarial valua- tions will be required on an annual basis as at December 31, 2011 for all Canadian plans, or when deemed appropriate by the OSFI. 38 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis The latest actuarial valuation of the CN Pension Plan for funding of the required contributions mainly to strengthen the financial po- purposes was conducted as at December 31, 2008 and indicated a sition of its main pension plan, the CN Pension Plan. The Company funding excess on a going-concern and solvency basis. The Company’s has been advised by the OSFI that this contribution can be treated next actuarial valuation required as at December 31, 2011 will be per- as a prepayment against its 2012 pension deficit funding require- formed in 2012. While this actuarial valuation is expected to identify a ments. As a result, the Company’s cash contributions for 2012 going concern surplus of approximately $1 billion, on a solvency basis are expected to be in the range of approximately $275 million a funding deficit of approximately $1.4 billion is expected due to the to $575 million for all its pension plans and include a voluntary level of interest rates applicable during that measurement period and contribution of approximately $150 million to $450 million. The the pension plan asset returns. The federal pension legislation requires Company expects cash from operations and its other sources of fi- funding deficits, as calculated under current pension regulations, to be nancing to be sufficient to meet its 2012 funding obligations. paid over a number of years. Actuarial valuations are also required an- Adverse changes to the assumptions used to calculate the nually for the Company’s U.S. pension plans. Company’s funding status, particularly the discount rate, as well In 2011, in anticipation of its future funding requirements, the as changes to existing federal pension legislation could signifi- Company made voluntary contributions of $350 million in excess cantly impact the Company’s future contributions. Information disclosed by major pension plan The following table provides the Company’s plan assets by category, projected benefit obligation at end of year, as well as Company and employee contributions by major defined benefit pension plan: In millions Plan assets by category December 31, 2011 BC Rail Ltd Pension Plan Pension Plan CN U.S. and other plans Total Cash and short-term investments $ 976 $ 36 $ 14 $ 1,026 Bonds Mortgages Equities Real estate Oil and gas Infrastructure Absolute return Other Total plan assets Projected benefit obligation at end of year Company contributions in 2011 Employee contributions in 2011 3,636 172 5,945 206 1,186 680 1,158 33 165 6 196 7 42 24 38 14 74 - 91 1 4 3 4 8 3,875 178 6,232 214 1,232 707 1,200 55 $ 13,992 $ 528 $ 199 $ 14,719 $ 14,514 $ 533 $ 501 $ 15,548 $ 422 $ 15 $ 21 $ 458 $ 54 $ - $ - $ 54 Additional disclosures are provided in Note 12 - Pensions and other postretirement benefits, to the Company’s Annual Consolidated Financial Statements. Income taxes establish a valuation allowance for its deferred income tax assets, The Company follows the asset and liability method of account- and if it is deemed more likely than not that its deferred income ing for income taxes. Under the asset and liability method, the tax assets will not be realized, a valuation allowance is recorded. change in the net deferred income tax asset or liability is in- The ultimate realization of deferred income tax assets is depen- cluded in the computation of net income or Other comprehen- dent upon the generation of future taxable income during the sive income (loss). Deferred income tax assets and liabilities are periods in which those temporary differences become deductible. measured using enacted income tax rates expected to apply to Management considers the scheduled reversals of deferred in- taxable income in the years in which temporary differences are come tax liabilities including the available carryback and carryfor- expected to be recovered or settled. As a result, a projection of ward periods, projected future taxable income, and tax planning taxable income is required for those years, as well as an assump- strategies in making this assessment. As at December 31, 2011, tion of the ultimate recovery/settlement period for temporary in order to fully realize all of the deferred income tax assets, the differences. The projection of future taxable income is based on Company will need to generate future taxable income of approxi- management’s best estimate and may vary from actual taxable mately $1.6 billion and, based upon the level of historical taxable income. On an annual basis, the Company assesses the need to income and projections of future taxable income over the periods Canadian National Railway Company U.S. GAAP 2011 Annual Report 39 Management’s Discussion and Analysis in which the deferred income tax assets are deductible, manage- future-enacted income tax rates which could change due to fiscal ment believes it is more likely than not that the Company will re- budget changes and/or changes in income tax laws. As a result, alize the benefits of these deductible differences. Management a change in the timing and/or the income tax rate at which the has assessed the impacts of the current economic environment components will reverse, could materially affect deferred income and concluded there are no significant impacts to its assertions tax expense as recorded in the Company’s results of operations. for the realization of deferred income tax assets. A one-percentage-point change in the Company’s reported effec- In addition, Canadian, or domestic, tax rules and regulations, tive income tax rate would have the effect of changing the in- as well as those relating to foreign jurisdictions, are subject to come tax expense by $34 million in 2011. interpretation and require judgment by the Company that may From time to time, the federal, provincial, and state govern- be challenged by the taxation authorities upon audit of the filed ments enact new corporate income tax rates resulting in either income tax returns. Tax benefits are recognized if it is more likely lower or higher tax liabilities. Such enactments occurred in each than not that the tax position will be sustained on examination of 2011 and 2009 and resulted in a net deferred income tax by the taxation authorities. As at December 31, 2011, the total expense of $40 million and a deferred income tax recovery of amount of gross unrecognized tax benefits was $46 million, be- $126 million, respectively, with corresponding adjustments to the fore considering tax treaties and other arrangements between Company’s net deferred income tax liability. taxation authorities. The amount of net unrecognized tax benefits For the year ended December 31, 2011, the Company re- as at December 31, 2011 was $35 million. If recognized, all of the corded total income tax expense of $899 million ($772 million net unrecognized tax benefits as at December 31, 2011 would in 2010 and $407 million in 2009), of which $531 million was affect the effective tax rate. The Company believes that it is rea- a deferred income tax expense and included a net deferred in- sonably possible that approximately $16 million of the net unrec- come tax expense of $40 million resulting from the enactment ognized tax benefits as at December 31, 2011 related to various of state corporate income tax rate changes and other legislated federal, state, and provincial income tax matters, each of which state tax revisions, and a current income tax recovery of $11 mil- are individually insignificant, may be recognized over the next lion relating to certain fuel costs attributed to various wholly- twelve months as a result of settlements and a lapse of the ap- owned subsidiaries’ fuel consumption in prior periods. In 2010, plicable statute of limitations. In Canada, the Company’s federal $418 million of the reported income tax expense was for deferred income tax returns filed for the years 2007 to 2010 and the pro- income taxes. In 2009, $138 million of the reported income tax vincial income tax returns filed for the years 2006 to 2010 remain expense was for deferred income taxes, and included a deferred subject to examination by the taxation authorities. In the second income tax recovery of $157 million. Of this amount, $126 mil- quarter of 2011, the taxation authorities commenced examina- lion resulted from the enactment of lower provincial corporate tions of the Company’s federal income tax returns for 2007 and income tax rates, $16 million resulted from the recapitalization 2008 which are expected to be completed during 2012. Current of a foreign investment, and $15 million resulted from the reso- on-going examinations on specific tax positions taken for federal lution of various income tax matters and adjustments related to and provincial income tax returns filed for the 2006 year are also tax filings of prior years. The Company’s net deferred income tax expected to be completed during 2012. In the U.S., both the fed- liability at December 31, 2011 was $5,287 million ($5,099 mil- eral and state income tax returns filed for the years 2007 to 2010 lion at December 31, 2010). Additional disclosures are provided in remain subject to examination by the taxation authorities. In the Note 14 - Income taxes, to the Company’s Annual Consolidated fourth quarter of 2011, the taxation authorities commenced ex- Financial Statements. aminations of the Company’s Indiana state income tax returns for 2008 to 2010 and are expected to be completed during 2012. Business risks Current on-going examinations of the Company’s Wisconsin state In the normal course of business, the Company is exposed to vari- income tax returns for 2003 to 2006 are also expected to be ous business risks and uncertainties that can have an effect on completed during 2012. The Company does not anticipate any the Company’s results of operations, financial position, or liquid- significant impacts to its results of operations or financial position ity. While some exposures may be reduced by the Company’s risk as a result of the final resolutions of such matters. management strategies, many risks are driven by external factors The Company’s deferred income tax assets are mainly com- beyond the Company’s control or are of a nature which cannot posed of temporary differences related to the pension liabil- be eliminated. The following is a discussion of key areas of busi- ity, accruals for personal injury claims and other reserves, other ness risks and uncertainties. postretirement benefits liability, and net operating losses and tax credit carryforwards. The majority of these accruals will be paid Competition out over the next five years. The Company’s deferred income tax The Company faces significant competition, including from rail liabilities are mainly composed of temporary differences related carriers and other modes of transportation, and is also affected to properties. The reversal of temporary differences is expected at by its customers’ flexibility to select among various origins and 40 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis destinations, including ports, in getting their products to mar- operations. As a result, the Company incurs significant operating ket. Specifically, the Company faces competition from Canadian and capital costs, on an ongoing basis, associated with environ- Pacific Railway Company (CP), which operates the other major rail mental regulatory compliance and clean-up requirements in its system in Canada and services most of the same industrial areas, railroad operations and relating to its past and present ownership, commodity resources and population centers as the Company; operation or control of real property. major U.S. railroads and other Canadian and U.S. railroads; While the Company believes that it has identified the costs long-distance trucking companies, and transportation via the St. likely to be incurred for environmental matters in the next several Lawrence-Great Lakes Seaway and the Mississippi River. In addi- years based on known information, the discovery of new facts, tion, while railroads must build or acquire and maintain their rail changes in laws, the possibility of releases of hazardous materi- systems, motor carriers and barges are able to use public rights- als into the environment and the Company’s ongoing efforts to of-way that are built and maintained by public entities without identify potential environmental liabilities that may be associated paying fees covering the entire costs of their usage. with its properties may result in the identification of additional Competition is generally based on the quality and the reliabil- environmental liabilities and related costs. ity of the service provided, access to markets, as well as price. In railroad and related transportation operations, it is possible Factors affecting the competitive position of customers, including that derailments or other accidents, including spills and releases exchange rates and energy cost, could materially adversely af- of hazardous materials, may occur that could cause harm to hu- fect the demand for goods supplied by the sources served by the man health or to the environment. In addition, the Company is Company and, therefore, the Company’s volumes, revenues and also exposed to potential catastrophic liability risk, faced by the profit margins. Factors affecting the general market conditions railroad industry generally, in connection with the transportation of for our customers can result in an imbalance of transportation ca- toxic-by-inhalation hazardous materials such as chlorine and anhy- pacity relative to demand. An extended period of supply/demand drous ammonia, commodities that the Company may be required imbalance could negatively impact market rate levels for all trans- to transport to the extent of its common carrier obligations. As a portation services, and more specifically the Company’s ability result, the Company may incur costs in the future, which may be to maintain or increase rates. This, in turn, could materially and material, to address any such harm, compliance with laws or other adversely affect the Company’s business, results of operations or risks, including costs relating to the performance of clean-ups, pay- financial position. ment of environmental penalties and remediation obligations, and The level of consolidation of rail systems in the United States damages relating to harm to individuals or property. has resulted in larger rail systems that are able to offer seamless The environmental liability for any given contaminated site var- services in larger market areas and, accordingly, compete ef- ies depending on the nature and extent of the contamination; the fectively with the Company in numerous markets. This requires available clean-up techniques; evolving regulatory standards gov- the Company to consider arrangements or other initiatives that erning environmental liability; and the number of potentially re- would similarly enhance its own service. sponsible parties and their financial viability. As such, the ultimate There can be no assurance that the Company will be able to com- cost of addressing known contaminated sites cannot be definitively pete effectively against current and future competitors in the trans- established. Also, additional contaminated sites yet unknown may portation industry, and that further consolidation within the trans- be discovered or future operations may result in accidental releases. portation industry and legislation allowing for more leniency in size While some exposures may be reduced by the Company’s risk and weight for motor carriers will not adversely affect the Company’s mitigation strategies (including periodic audits, employee training competitive position. No assurance can be given that competitive programs and emergency plans and procedures), many environ- pressures will not lead to reduced revenues, profit margins or both. mental risks are driven by external factors beyond the Company’s Environmental matters control or are of a nature which cannot be completely eliminat- ed. Therefore, there can be no assurance, notwithstanding the The Company’s operations are subject to numerous federal, pro- Company’s mitigation strategies that liabilities or costs related to vincial, state, municipal and local environmental laws and regula- environmental matters will not be incurred in the future or that tions in Canada and the United States concerning, among other environmental matters will not have a material adverse effect on things, emissions into the air; discharges into waters; the genera- the Company’s results of operations, financial position or liquidity, tion, handling, storage, transportation, treatment and disposal and reputation in a particular quarter or fiscal year. of waste, hazardous substances and other materials; decommis- sioning of underground and aboveground storage tanks; and soil Personal injury and other claims and groundwater contamination. A risk of environmental liability In the normal course of business, the Company becomes involved is inherent in railroad and related transportation operations; real in various legal actions seeking compensatory and occasionally estate ownership, operation or control; and other commercial punitive damages, including actions brought on behalf of various activities of the Company with respect to both current and past purported classes of claimants and claims relating to employee Canadian National Railway Company U.S. GAAP 2011 Annual Report 41 Management’s Discussion and Analysis and third-party personal injuries, occupational disease, and prop- be able to renew and have its collective agreements ratified without erty damage, arising out of harm to individuals or property alleg- any strikes or lockouts or that the resolution of these collective bar- edly caused by, but not limited to, derailments or other accidents. gaining negotiations will not have a material adverse effect on the The Company maintains provisions for such items, which it con- Company’s results of operations or financial position. siders to be adequate for all of its outstanding or pending claims and benefits from insurance coverage for occurrences in excess of U.S. workforce certain amounts. The final outcome with respect to actions out- As at December 31, 2011, CN employed a total of 6,917 em- standing or pending at December 31, 2011, or with respect to ployees in the United States, of which 5,732 were unionized future claims, cannot be predicted with certainty, and therefore employees. there can be no assurance that their resolution will not have a As of February 2012, the Company had in place agreements material adverse effect on the Company’s results of operations, with bargaining units representing the entire unionized work- financial position or liquidity, in a particular quarter or fiscal year. force at Grand Trunk Western Railroad Company (GTW); Duluth, Labor negotiations Canadian workforce Winnipeg and Pacific Railway Company (DWP); Illinois Central Railroad Company (ICRR); companies owned by CCP Holdings, Inc. (CCP); Duluth, Missabe & Iron Range Railway Company As at December 31, 2011, CN employed a total of 16,313 em- (DMIR); Bessemer & Lake Erie Railroad Company (BLE); The ployees in Canada, of which 12,301 were unionized employees. Pittsburgh and Conneaut Dock Company (PCD); EJ&E; and all From time to time, the Company negotiates to renew collective but one of the unions at companies owned by Wisconsin Central agreements with various unionized groups of employees. In such Transportation Corporation (WC). Agreements in place have vari- cases, the collective agreements remain in effect until the bargain- ous moratorium provisions, ranging from 2004 to 2014, which ing process has been exhausted as per the Canada Labour Code. preserve the status quo in respect of given areas during the terms On September 1, 2010, CN and the Canadian Auto Workers of such moratoriums. Several of these agreements are currently (CAW) had initiated the bargaining process for the renewal of four under renegotiation. The WC rail traffic controllers are in the pro- collective agreements applicable to clerical and intermodal employ- cess of negotiating their first collective agreement. ees, shopcraft mechanics and electricians, excavator operators and In conjunction with a notice of exemption filed with the owner operator truck drivers working for a CN subsidiary, which Surface Transportation Board (STB) on April 8, 2011, effective were to expire on December 31, 2010. On January 24, 2011, the May 8, 2011, allowing for the intra-corporate merger of DWP, parties reached agreements for all groups, thus concluding bar- DMIR and WC, the Company served notice to unions represent- gaining without a labor disruption. The agreements were ratified ing train and engine service employees on those properties to on February 14, 2011 and will expire on December 31, 2014. consolidate the collective agreements and allow the transaction On September 15, 2011 and October 11, 2011, CN and the to be implemented. This process is governed by the New York Teamsters Canada Rail Conference (TCRC) initiated the bargain- Dock labor protective conditions which provide a mechanism ing process for the renewal of the collective agreements covering to ensure that the change is achieved without disruption in the approximately 200 rail traffic controllers and 1,500 locomotive event that new agreements cannot be reached voluntarily. engineers respectively, which were set to expire on December 31, Following notice of this transaction, on August 2, 2011, a ten- 2011. On December 12, 2011, the parties reached a tentative tative agreement was reached with the United Transportation Union three-year agreement with the locomotive engineers expiring on (UTU) to merge the collective bargaining agreements of those three December 31, 2014. The agreement was ratified by the locomotive properties under the general terms of the WC agreement and to ex- engineers on January 27, 2012 and the wage increases are retroac- tend that agreement for a period of three years ending December 31, tive to January 1, 2012. Bargaining for the renewal of the collective 2014. The agreement was ratified on October 14, 2011. agreement governing the rail traffic controllers is still ongoing. As a similar voluntary agreement to consolidate the locomo- On September 21, 2011, CN and the Steelworkers (USW) initi- tive engineer’s collective bargaining agreements (on those prop- ated the bargaining process for the renewal of the collective agree- erties) was not achieved, the matter was progressed to binding ment covering approximately 2,900 track maintenance employees, arbitration for resolution. On November 29, 2011, the Arbitrator which expired on December 31, 2011. On December 15, 2011, the assigned to the New York Dock proceedings rendered a decision parties reached a tentative agreement. The result of the ratification that allows CN to consolidate the locomotive engineer collective process by the employees is expected before February 15, 2012. bargaining agreements effective January 1, 2012. In accordance with the terms of the agreements and conditions, the merger was Disputes with bargaining units could potentially result in strikes, work consummated on December 31, 2011. stoppages, slowdowns and loss of business. Future labor agree- ments or renegotiated agreements could increase labor and fringe The general approach to labor negotiations by U.S. Class I railroads is to bargain on a collective national basis. GTW, DWP, benefits expenses. There can be no assurance that the Company will ICRR, CCP, WC, DMIR, BLE, PCD and EJ&E have bargained on a 42 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis local basis rather than holding national, industry-wide negotia- and announced that it intended to implement certain steps to im- tions because they believe it results in agreements that better ad- prove the entire rail supply chain, including potentially tabling leg- dress both the employees’ concerns and preferences, and the rail- islation to give shippers the right to a service agreement. As part ways’ actual operating environment. However, local negotiations of its response to the panel’s report, the Government appointed may not generate federal intervention in a strike or lockout situa- on October 31, 2011, a facilitator to lead a rail freight service dis- tion, since a dispute may be localized. The Company believes the cussion process. To date, the Government has introduced no new potential mutual benefits of local bargaining outweigh the risks. legislation. Where negotiations are ongoing, the terms and conditions of existing agreements generally continue to apply until new agree- No assurance can be given that any current or future legislative ments are reached or the processes of the Railway Labor Act have action by the federal government or other future government ini- been exhausted. tiatives will not materially adversely affect the Company’s results There can be no assurance that there will not be any work action by any of the bargaining units with which the Company is cur- Economic regulation - U.S. of operations or financial position. rently in negotiations or that the resolution of these negotiations The STB serves as both an adjudicatory and regulatory body and will not have a material adverse effect on the Company’s results has jurisdiction over railroad rate and service issues and rail re- of operations or financial position. Regulation structuring transactions such as mergers, line sales, line construc- tion and line abandonments. As such, various Company business transactions must gain prior regulatory approval, with attendant The Company’s rail operations in Canada are subject to (i) eco- risks and uncertainties. nomic regulation by the Canadian Transportation Agency (the On April 8, 2011, the Company filed with the STB a notice Agency) under the Canada Transportation Act (the CTA), and (ii) of exemption that would allow for the intra-corporate merger of safety regulation by the federal Minister of Transport under the WC, DMIR, and DWP. The transaction would simplify the corpo- Railway Safety Act and certain other statutes. The Company’s U.S. rate structure of CN’s U.S. operating subsidiaries and allow for rail operations are subject to (i) economic regulation by the STB operational efficiencies and service improvements. The notice be- and (ii) safety regulation by the Federal Railroad Administration came effective May 8, 2011, and the Company, after completing (FRA). labor implementing agreements, consummated the transaction on December 31, 2011. Economic regulation - Canada The STB has undertaken proceedings in a number of areas re- The CTA provides rate and service remedies, including final offer cently on rail issues. In 2010, the STB commenced a proceeding arbitration (FOA), competitive line rates and compulsory inter- to review the liability of third parties for rail car demurrage, and switching. In addition, various Company business transactions on February 24, 2011, it held a hearing to review the commodi- must gain prior regulatory approval, with attendant risks and ties and forms of service currently exempt from STB regulation. On uncertainties. June 22 - 23, 2011, the STB held a hearing on the current state of On August 12, 2008, Transport Canada announced the Terms competition in the railroad industry. The STB will be considering the of Reference for the Rail Freight Service Review to examine the comments on these matters and may take further action. services offered by CN and CP to Canadian shippers and cus- As part of the Passenger Rail Investment and Improvement tomers. The review was conducted in two phases. Phase 1 con- Act of 2008 (PRIIA), the U.S. Congress has authorized the STB to sisted of analytical work to achieve a better understanding of investigate any railroad over whose track Amtrak operates that the state of rail service. Phase 2 commenced on September 23, fails to meet an 80 percent on-time performance standard for 2009 with the appointment of a panel to develop recommenda- Amtrak operations extending over two calendar quarters and tions in consultation with stakeholders. Approximately 110 public to determine the cause of such failures. Compliance with this submissions were made, including three from CN, in response to mandate began with the third quarter of 2010 and is governed the panel’s invitation to all interested parties to provide written by performance metrics and standards jointly issued by the FRA submissions. The panel issued an interim report on October 8, and Amtrak on May 12, 2010. The Company is participating in a 2010, and filed its final report and recommendations with the railroad industry lawsuit filed in August 2011 in the U.S. District Minister of Transport and Infrastructure in December 2010. This Court in Washington, D.C. challenging the constitutionality of report, which was released to the public on March 18, 2011, rec- these performance metrics and standards. Should the STB com- ommends streamlined commercial dispute resolution, the estab- mence an investigation and determine that a failure to meet lishment of service level agreements with customers, and public these standards is due to the host railroad’s failure to provide reporting of various system metrics amongst other recommenda- preference to Amtrak, the STB is authorized to assess damages tions. The Government of Canada accepted the panel’s report against the host railroad. Canadian National Railway Company U.S. GAAP 2011 Annual Report 43 Management’s Discussion and Analysis The U.S. Congress has had under consideration for several On April 28, 2010, the STB held a hearing to review CN’s re- years various pieces of legislation that would increase federal porting on blocked crossing occurrences along the EJ&E line. On economic regulation of the railroad industry. During the 111th December 21, 2010, the STB concurred with the audit’s findings Congress (2009 - 2010), legislation to repeal the railroad indus- as to CN’s general compliance with the reporting and mitigation try’s limited antitrust exemptions was introduced in both Houses conditions it had imposed. The STB indicated that it will continue of Congress and was approved by the Senate and House Judiciary monitoring blocked crossing occurrences, asked for additional in- Committees. Broader legislation to modify the system of economic formation from CN on certain crossing areas for future quarterly regulation of the railroad industry was introduced and approved environmental reports, and indicated it would commence anoth- by the Senate Commerce Committee on December 17, 2009. If er audit in 2011. The STB also extended the original monitoring enacted, these bills would have made significant changes to the and oversight condition for an additional year. In a separate deci- economic regulatory system governing rail operations in the United sion, the STB imposed a US$250,000 civil penalty on CN, which States. The 111th Congress adjourned without taking final action the Company paid in January 2011, based on its finding that on this legislation. Broad legislation to modify economic regulation the Company breached the Board’s oversight requirement that of the rail industry (S. 158) and legislation to repeal the rail indus- it report all blocked crossing occurrences of 10 minutes or more try’s limited antitrust exemptions (S. 49) were introduced in 2011 in on the EJ&E line, regardless of cause. On October 14, 2011, as the Senate. S. 49 has also been approved by the Senate Judiciary supplemented on November 14, 2011, the Village of Barrington, Committee and there is no assurance that this or similar legislation IL has requested that the STB impose additional mitigation that will not progress through the legislative process. would require CN to fund the full cost of a grade separation at The acquisition of the EJ&E in 2009 followed an extensive regula- a location along the EJ&E line in Barrington. The Company has tory approval process by the STB, which included an Environmental filed comments at the STB responding to Barrington’s request. Impact Statement (EIS) that resulted in conditions imposed to miti- In December 2011, the STB directed a second audit of the gate municipalities’ concerns regarding increased rail activity expect- Company’s operational and environmental mitigation reporting ed along the EJ&E line (see Contractual obligations section of this to commence in early 2012. MD&A). The Company accepted the STB-imposed conditions with The resolution of matters that could arise during the STB’s one exception. The Company filed an appeal at the U.S. Court of remaining oversight of the transaction cannot be predicted with Appeals for the District of Columbia Circuit challenging the STB’s con- certainty, and therefore, there can be no assurance that their res- dition requiring the installation of grade separations at two locations olution will not have a material adverse effect on the Company’s along the EJ&E line at Company funding levels significantly beyond financial position or results of operations. prior STB practice. Appeals were also filed by certain communities The Company’s ownership of the former Great Lakes challenging the sufficiency of the EIS. On March 15, 2011, the Court Transportation vessels is subject to regulation by the U.S. Coast Guard denied the CN and community appeals. As such, the Company esti- and the Department of Transportation, Maritime Administration, mates its total remaining commitment related to the acquisition to be which regulate the ownership and operation of vessels operat- approximately $130 million. The commitment for the grade separa- ing on the Great Lakes and in U.S. coastal waters. In addition, the tion projects is based on estimated costs provided by the STB at the Environmental Protection Agency (EPA) has authority to regulate air time of acquisition and could be subject to adjustment. emissions from these vessels. On August 28, 2009, the EPA issued The STB also imposed a five-year monitoring and oversight a proposed rule to extend an ongoing rulemaking to limit sulfur condition, during which the Company is required to file with emissions for ocean-going vessels to operations in the Great Lakes. the STB monthly operational reports as well as quarterly reports The EPA’s proposed rule would have had an adverse impact on the on the implementation status of the STB-imposed mitigation Company’s Great Lakes Fleet operations. The Company’s U.S.-flag conditions. This permits the STB to take further action if there vessel operator filed comments on September 28, 2009 in the pro- is a material change in the facts and circumstances upon which ceeding. On December 22, 2009, the EPA issued its final emissions it relied in imposing the specific mitigation conditions. In early regulations, which addressed many of Great Lakes Fleet’s concerns. 2010, the STB directed an audit of the Company’s EJ&E opera- In addition, the U.S. Coast Guard on August 28, 2009 proposed to tional and environmental mitigation reports and released the amend its regulations on ballast water management; the Company’s results of the audit to the public in April 2010. The audit gen- U.S.-flag vessel operator is participating in this rulemaking proceed- erally confirmed CN’s compliance with the STB’s reporting con- ing. On November 8, 2011, the Federal Maritime Commission (FMC), ditions and its cooperation with local communities to mitigate which has authority over oceanborne transport of cargo into and out the adverse impacts of additional traffic expected as a result of of the U.S., initiated a Notice of Inquiry to examine whether the U.S. the EJ&E transaction. However, the audit recommended clarifica- Harbor Maintenance tax and other factors may be contributing to the tion of reporting requirements for blocked crossings on the EJ&E diversion of U.S.-bound cargo to Canadian and Mexican seaports, line. Based on the audit and subsequent direction by the STB, CN which could affect CN rail operations. The Company filed comments provided requested information to the STB on April 26, 2010. in this proceeding on January 9, 2012. 44 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis No assurance can be given that these or any future regulatory No assurance can be given that these or any future regulatory initiatives by the U.S. federal government will not materially ad- initiatives by the Canadian and U.S. federal governments will versely affect the Company’s results of operations, or its competi- not materially adversely affect the Company’s results of opera- tive and financial position. tions, or its competitive and financial position. Safety regulation - Canada Security Rail safety regulation in Canada is the responsibility of Transport The Company is subject to statutory and regulatory direc- Canada, which administers the Canadian Railway Safety Act, as tives in the U.S. addressing homeland security concerns. In well as the rail portions of other safety-related statutes. The fol- the U.S., safety matters related to security are overseen by the lowing actions have been taken by the federal government: Transportation Security Administration (TSA), which is part of the (i) In 2008, a full review of the Railway Safety Act was conducted U.S. Department of Homeland Security (DHS) and the Pipeline by the Railway Safety Act Review Panel (Review Panel) and and Hazardous Materials Safety Administration (PHMSA), which, their report was tabled in the House of Commons. The Report like the FRA, is part of the U.S. Department of Transportation. includes more than 50 recommendations to improve rail safety Border security falls under the jurisdiction of U.S. Customs and in Canada but concludes that the current framework of the Border protection (CBP), which is part of the DHS. In Canada, the Railway Safety Act is sound. Company is subject to regulation by the Canada Border Services (ii) On June 4, 2010, the Minister of Transport tabled Bill C-33 Agency (CBSA). More specifically, the Company is subject to: proposing a number of amendments to the Railway Safety Act (i) Border security arrangements, pursuant to an agreement the addressing the recommendations made by the Review Panel. Company and CP entered into with the CBP and the CBSA. The Committee completed its study of Bill C-33, but the Bill (ii) The CBP’s Customs-Trade Partnership Against Terrorism died on the Order Paper when Parliament was dissolved in (C-TPAT) program and designation as a low-risk carrier under March 2011. On October 6, 2011, the Government tabled CBSA’s Customs Self-Assessment (CSA) program. Bill S-4 which included essentially the same provisions as those (iii) Regulations imposed by the CBP requiring advance notifica- that were in Bill C-33. tion by all modes of transportation for all shipments into the U.S. The CBSA is also working on similar requirements for Safety regulation - U.S. Canada-bound traffic. Rail safety regulation in the U.S. is the responsibility of the FRA, (iv) Inspection for imported fruits and vegetables grown in which administers the Federal Railroad Safety Act, as well as Canada and the agricultural quarantine and inspection (AQI) the rail portions of other safety statutes. In 2008, the U.S. fed- user fee for all traffic entering the U.S. from Canada. eral government enacted legislation reauthorizing the Federal Railroad Safety Act. This legislation covers a broad range of The Company has worked with the Association of American safety issues, including fatigue management, PTC, grade cross- Railroads to develop and put in place an extensive industry-wide ings, bridge safety, and other matters. The legislation requires all Class I railroads and intercity passenger and commuter railroads to implement a PTC system by December 31, 2015 on main- security plan to address terrorism and security-driven efforts by state and local governments seeking to restrict the routings of certain hazardous materials. If such state and local routing restric- line track where intercity passenger railroads and commuter tions were to go into force, they would be likely to add to security railroads operate and where toxic-by-inhalation hazardous ma- concerns by foreclosing the Company’s most optimal and secure terials are transported. PTC is a collision avoidance technology transportation routes, leading to increased yard handling, longer intended to override locomotive controls and stop a train before hauls, and the transfer of traffic to lines less suitable for moving an accident. The Company is taking steps to ensure implemen- hazardous materials, while also infringing upon the exclusive and tation in accordance with the new law, including working with other Class I railroads to satisfy the requirements for U.S. net- work interoperability. The Company’s PTC Implementation Plan, uniform federal oversight over railroad security matters. Transportation of hazardous materials submitted in April 2010, has been approved by the FRA. Total The Company may be required to transport toxic-by-inhalation implementation costs associated with PTC are estimated to be (TIH) hazardous materials to the extent of its common carrier obli- US$220 million. The legislation also caps the number of on-duty gations and, as such, is exposed to additional regulatory oversight. and limbo time hours for certain rail employees on a monthly (i) The PHMSA requires carriers operating in the U.S. to report basis. The Company is taking appropriate steps and working annually the volume and route-specific data for cars contain- with the FRA to ensure that its operations conform to the law’s ing these commodities; conduct a safety and security risk anal- requirements. ysis for each used route; identify a commercially practicable alternative route for each used route; and select for use the practical route posing the least safety and security risk. Canadian National Railway Company U.S. GAAP 2011 Annual Report 45 Management’s Discussion and Analysis (ii) The TSA requires rail carriers to provide upon request, within Terrorism and international conflicts five minutes for a single car and 30 minutes for multiple cars, Potential terrorist actions can have a direct or indirect impact on location and shipping information on cars on their networks the transportation infrastructure, including railway infrastructure in containing TIH materials and certain radioactive or explosive North America, and interfere with the free flow of goods. Rail lines, materials; and ensure the secure, attended transfer of all such facilities and equipment could be directly targeted or become indi- cars to and from shippers, receivers and other carriers that rect casualties, which could interfere with the free flow of goods. will move from, to, or through designated high-threat urban International conflicts can also have an impact on the Company’s areas. markets. Government response to such events could adversely af- (iii) The PHMSA has issued regulations to enhance the crashwor- fect the Company’s operations. Insurance coverage and premiums thiness protection of tank cars used to transport TIH and to could also increase significantly or become unavailable. limit the operating conditions of such cars. (iv) In Canada, the Transportation of Dangerous Goods Act es- Customer credit risk tablishes the safety requirements for the transportation of In the normal course of business, the Company monitors the fi- goods classified as dangerous and enables the establishment nancial condition and credit limits of its customers and reviews of regulations for security training and screening of personnel the credit history of each new customer. Although the Company working with dangerous goods, as well as the development believes there are no significant concentrations of credit risk, eco- of a program to require a transportation security clearance for nomic conditions can affect the Company’s customers and can dangerous goods and that dangerous goods be tracked dur- result in an increase to the Company’s credit risk and exposure ing transport. to business failures of its customers. To manage its credit risk on an ongoing basis, the Company’s focus is on keeping the average While the Company will continue to work closely with the CBSA, daily sales outstanding within an acceptable range and working CBP, and other Canadian and U.S. agencies, as described above, with customers to ensure timely payments, and in certain cases, no assurance can be given that these and future decisions by the requiring financial security, including letters of credit. A wide- U.S., Canadian, provincial, state, or local governments on home- spread deterioration of customer credit and business failures of land security matters, legislation on security matters enacted by customers could have a material adverse effect on the Company’s the U.S. Congress or Parliament, or joint decisions by the industry results of operations, financial position or liquidity. in response to threats to the North American rail network, will not materially adversely affect the Company’s results of opera- Liquidity tions, or its competitive and financial position. Disruptions in the financial markets or deterioration of the Other risks Economic conditions Company’s credit ratings could hinder the Company’s access to external sources of funding to meet its liquidity needs. There can be no assurance that changes in the financial markets will not The Company, like other railroads, is susceptible to changes in have a negative effect on the Company’s liquidity and its access the economic conditions of the industries and geographic areas to capital at acceptable rates. that produce and consume the freight it transports or the sup- plies it requires to operate. In addition, many of the goods and Supplier risk commodities carried by the Company experience cyclicality in de- The Company operates in a capital-intensive industry where the mand. Many of the bulk commodities the Company transports complexity of rail equipment limits the number of suppliers avail- move offshore and are affected more by global rather than North able. The supply market could be disrupted if changes in the American economic conditions. Adverse North American and economy caused any of the Company’s suppliers to cease produc- global economic conditions, or economic or industrial restructur- tion or to experience capacity or supply shortages. This could also ing, that affect the producers and consumers of the commodities result in cost increases to the Company and difficulty in obtain- carried by the Company, including customer insolvency, may have ing and maintaining the Company’s rail equipment and materi- a material adverse effect on the volume of rail shipments and/ als. Since the Company also has foreign suppliers, international or revenues from commodities carried by the Company, and thus relations, trade restrictions and global economic and other condi- materially and negatively affect its results of operations, financial tions may potentially interfere with the Company’s ability to pro- position, or liquidity. Trade restrictions cure necessary equipment. To manage its supplier risk, it is the Company’s long-standing practice to ensure that more than one source of supply for a key product or service, where feasible, is Global as well as North American trade conditions, including available. Widespread business failures of, or restrictions on sup- trade barriers on certain commodities, may interfere with the free pliers, could have a material adverse effect on the Company’s re- circulation of goods across Canada and the U.S. sults of operations or financial position. 46 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Discussion and Analysis Pensions to retire or leave through normal attrition (death, termination, Overall return in the capital markets and the level of interest rates resignation) within the next five-year period. The Company moni- affect the funded status of the Company’s defined benefit pen- tors employment levels to ensure that there is an adequate sup- sion plans. ply of personnel to meet rail service requirements. However, the For accounting purposes, the funded status of all pen- Company’s efforts to attract and retain qualified personnel may sion plans is calculated at the measurement date, which for the be hindered by specific conditions in the job market. No assur- Company is December 31, using generally accepted accounting ance can be given that demographic or other challenges will not principles. Adverse changes with respect to pension plan returns materially adversely affect the Company’s results of operations or and the level of interest rates from the last measurement date its financial position. may have a material adverse effect on the funded status and may significantly impact future pension income or expense. Fuel costs For funding purposes, the funded status of the Canadian pen- The Company, like other railroads, is susceptible to the volatil- sion plans is calculated to determine the required level of contri- ity of fuel prices due to changes in the economy or supply dis- bution using going-concern and solvency scenarios as prescribed ruptions. Fuel shortages can occur due to refinery disruptions, under pension legislation and subject to guidance issued by the production quota restrictions, climate, and labor and political Canadian Institute of Actuaries. Adverse changes with respect to instability. Rising fuel prices could materially adversely affect the pension plan returns and the level of interest rates from the date Company’s expenses. As such, CN has implemented a fuel sur- of the last actuarial valuations as well as changes to existing fed- charge program with a view of offsetting the impact of rising eral pension legislation may significantly impact future pension fuel prices. The surcharge applied to customers is determined in contributions and have a material adverse effect on the funded the second calendar month prior to the month in which it is ap- status of the plans and the Company’s results of operations. The plied, and is calculated using the average monthly price of West- Company’s funding requirements are determined upon comple- Texas Intermediate crude oil (WTI) for revenue-based tariffs and tion of actuarial valuations. Due to recent legislative changes, On-Highway Diesel (OHD) for mileage-based tariffs. Increases in such actuarial valuations will be required on an annual basis ef- fuel prices or supply disruptions may materially adversely affect fective for years ending on or after December 31, 2011 for all the Company’s results of operations, financial position or liquidity. Canadian plans, or when deemed appropriate by the OSFI. The federal pension legislation allows funding deficits to be paid over Foreign currency a number of years. Actuarial valuations are also required annually The Company conducts its business in both Canada and the U.S. for the Company’s U.S. pension plans. and as a result, is affected by currency fluctuations. The estimated In 2011, in anticipation of its future funding requirements, annual impact on net income of a year-over-year one-cent change the Company made voluntary contributions of $350 million in in the Canadian dollar relative to the US dollar is in the range of excess of the required contributions mainly to strengthen the fi- $5 million to $10 million. Changes in the exchange rate between nancial position of its main pension plan, the CN Pension Plan. the Canadian dollar and other currencies (including the US dollar) The Company has been advised by the OSFI that this contribution make the goods transported by the Company more or less com- can be treated as a prepayment against its 2012 pension defi- petitive in the world marketplace and thereby further affect the cit funding requirements. As a result, the Company’s cash con- Company’s revenues and expenses. tributions for 2012 are expected to be in the range of approxi- mately $275 million to $575 million for all its pension plans and Reliance on technology include a voluntary contribution of approximately $150 million to The Company relies on information technology in all aspects of $450 million. its business. While the Company has business continuity and di- The Company expects cash from operations and its oth- saster recovery plans in place, a significant disruption or failure er sources of financing to be sufficient to meet its funding of its information technology systems could result in service inter- obligation. Availability of qualified personnel ruptions, safety failures, security violations, regulatory compliance failures or other operational difficulties and compromise corpo- rate information and assets against intruders and, as such, could The Company, like other companies in North America, may ex- adversely affect the Company’s results of operations, financial perience demographic challenges in the employment levels of its position or liquidity. If the Company is unable to acquire or imple- workforce. Changes in employee demographics, training require- ment new technology, it may suffer a competitive disadvantage, ments and the availability of qualified personnel, particularly lo- which could also have an adverse effect on the Company’s results comotive engineers and trainmen, could negatively impact the of operations, financial position or liquidity. Company’s ability to meet demand for rail service. The Company expects that approximately 45% of its workforce will be eligible Canadian National Railway Company U.S. GAAP 2011 Annual Report 47 Management’s Discussion and Analysis Transportation network disruptions Controls and procedures Due to the integrated nature of the North American freight The Company’s Chief Executive Officer and its Chief Financial transportation infrastructure, the Company’s operations may be Officer, after evaluating the effectiveness of the Company’s “dis- negatively affected by service disruptions of other transportation closure controls and procedures” (as defined in Exchange Act links such as ports and other railroads which interchange with Rules 13a-15(e) and 15d-15(e)) as of December 31, 2011, have the Company. A significant prolonged service disruption of one concluded that the Company’s disclosure controls and procedures or more of these entities could have an adverse effect on the were effective. Company’s results of operations, financial position or liquid- During the fourth quarter ended December 31, 2011, there ity. Furthermore, deterioration in the cooperative relationships was no change in the Company’s internal control over financial with the Company’s connecting carriers could directly affect the reporting that has materially affected, or is reasonably likely to Company’s operations. materially affect, the Company’s internal control over financial reporting. Weather and climate change As of December 31, 2011, management has assessed the The Company’s success is dependent on its ability to operate its effectiveness of the Company’s internal control over finan- railroad efficiently. Severe weather and natural disasters, such as cial reporting using the criteria set forth by the Committee of extreme cold or heat, flooding, drought, hurricanes and earth- Sponsoring Organizations of the Treadway Commission (COSO) quakes, can disrupt operations and service for the railroad, af- in Internal Control - Integrated Framework. Based on this assess- fect the performance of locomotives and rolling stock, as well ment, management has determined that the Company’s internal as disrupt operations for both the Company and its customers. control over financial reporting was effective as of December 31, Climate change, including the impact of global warming, has 2011, and issued Management’s Report on Internal Control over the potential physical risk of increasing the frequency of adverse Financial Reporting dated February 3, 2012 to that effect. weather events, which can disrupt the Company’s operations, damage its infrastructure or properties, or otherwise have a ma- The Company’s 2011 Annual Information Form (AIF) and Form terial adverse effect on the Company’s results of operations, fi- 40-F, may be found on SEDAR at www.sedar.com and on EDGAR nancial position or liquidity. In addition, although the Company at www.sec.gov, respectively. Copies of such documents, as believes that the growing support for climate change legisla- well as the Company’s Notice of Intention to Make a Normal tion is likely to result in changes to the regulatory framework in Course Issuer Bid, may be obtained by contacting the Corporate Canada and the U.S., it is too early to predict the manner or de- Secretary’s office. gree of such impact on the Company at this time. Restrictions, caps, taxes, or other controls on emissions of greenhouse gas- Montreal, Canada ses, including diesel exhaust, could significantly increase the February 3, 2012 Company’s capital and operating costs or affect the markets for, or the volume of, the goods the Company carries thereby resulting in a material adverse effect on operations, financial po- sition, results of operations or liquidity. More specifically, climate change legislation and regulation could (a) affect CN’s utility coal customers due to coal capacity being replaced with natural gas generation and renewable energy; (b) make it difficult for CN’s customers to produce products in a cost-competitive manner due to increased energy costs; and (c) increase legal costs related to defending and resolving legal claims and other litigation related to climate change. 48 2011 Annual Report U.S. GAAP Canadian National Railway Company Management’s Report on Internal Control Report of Independent Registered Public Accounting Firm over Financial Reporting Management is responsible for establishing and maintaining ad- To the Shareholders and Board of Directors of the Canadian equate internal control over financial reporting. Internal control National Railway Company over financial reporting is a process designed to provide reason- able assurance regarding the reliability of financial reporting and We have audited the accompanying consolidated balance sheets the preparation of financial statements for external purposes of the Canadian National Railway Company (the “Company”) in accordance with generally accepted accounting principles. as of December 31, 2011 and 2010, and the related consoli- Because of its inherent limitations, internal control over financial dated statements of income, comprehensive income, changes in reporting may not prevent or detect misstatements. shareholders’ equity and cash flows for each of the years in the Management has assessed the effectiveness of the Company’s three-year period ended December 31, 2011. These consolidated internal control over financial reporting as of December 31, 2011 financial statements are the responsibility of the Company’s man- using the criteria set forth by the Committee of Sponsoring agement. Our responsibility is to express an opinion on these con- Organizations of the Treadway Commission (COSO) in Internal solidated financial statements based on our audits. Control - Integrated Framework. Based on this assessment, man- We conducted our audits in accordance with Canadian gener- agement has determined that the Company’s internal control ally accepted auditing standards and the standards of the Public over financial reporting was effective as of December 31, 2011. Company Accounting Oversight Board (United States). Those stan- KPMG LLP, an independent registered public accounting dards require that we plan and perform the audit to obtain rea- firm, has issued an unqualified audit report on the effectiveness sonable assurance about whether the financial statements are free of the Company’s internal control over financial reporting as of of material misstatement. An audit includes examining, on a test December 31, 2011 and has also expressed an unqualified au- basis, evidence supporting the amounts and disclosures in the fi- dit opinion on the Company’s 2011 consolidated financial state- nancial statements. An audit also includes assessing the accounting ments as stated in their Reports of Independent Registered Public principles used and significant estimates made by management, as Accounting Firm dated February 3, 2012. well as evaluating the overall financial statement presentation. We Claude Mongeau President and Chief Executive Officer February 3, 2012 Luc Jobin Executive Vice-President and Chief Financial Officer February 3, 2012 believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial po- sition of the Company as of December 31, 2011 and 2010, and its consolidated results of operations and its consolidated cash flows for each of the years in the three-year period ended December 31, 2011, in conformity with United States generally accepted accounting principles. We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial report- ing as of December 31, 2011, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”), and our report dated February 3, 2012 expressed an unqualified opinion on the effectiveness of the Company’s inter- nal control over financial reporting. KPMG LLP* Chartered Accountants Montreal, Canada February 3, 2012 * CA Auditor permit no. 10892 KPMG LLP is a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. KPMG Canada provides services to KPMG LLP. Canadian National Railway Company U.S. GAAP 2011 Annual Report 49 Report of Independent Registered Public Accounting Firm To the Shareholders and Board of Directors of the Canadian financial reporting includes those policies and procedures that National Railway Company (1) pertain to the maintenance of records that, in reasonable de- tail, accurately and fairly reflect the transactions and dispositions We have audited the Canadian National Railway Company’s of the assets of the company; (2) provide reasonable assurance (the “Company”) internal control over financial reporting as of that transactions are recorded as necessary to permit preparation December 31, 2011, based on criteria established in Internal of financial statements in accordance with generally accepted Control - Integrated Framework issued by the Committee accounting principles, and that receipts and expenditures of the of Sponsoring Organizations of the Treadway Commission company are being made only in accordance with authorizations (“COSO”). The Company’s management is responsible for main- of management and directors of the company; and (3) provide taining effective internal control over financial reporting, and reasonable assurance regarding prevention or timely detection of for its assessment of the effectiveness of internal control over unauthorized acquisition, use, or disposition of the company’s as- financial reporting included in the accompanying Management’s sets that could have a material effect on the financial statements. Report on Internal Control over Financial Reporting. Our respon- Because of its inherent limitations, internal control over finan- sibility is to express an opinion on the Company’s internal control cial reporting may not prevent or detect misstatements. Also, pro- over financial reporting based on our audit. jections of any evaluation of effectiveness to future periods are We conducted our audit in accordance with the standards of subject to the risk that controls may become inadequate because the Public Company Accounting Oversight Board (United States). of changes in conditions, or that the degree of compliance with Those standards require that we plan and perform the audit to the policies or procedures may deteriorate. obtain reasonable assurance about whether effective internal In our opinion, the Company maintained, in all material re- control over financial reporting was maintained in all material re- spects, effective internal control over financial reporting as of spects. Our audit included obtaining an understanding of internal December 31, 2011, based on criteria established in Internal control over financial reporting, assessing the risk that a material Control - Integrated Framework issued by the COSO. weakness exists, and testing and evaluating the design and oper- We also have audited, in accordance with Canadian gener- ating effectiveness of internal control based on the assessed risk. ally accepted auditing standards and the standards of the Public Our audit also included performing such other procedures as we Company Accounting Oversight Board (United States), the con- considered necessary in the circumstances. We believe that our solidated balance sheets of the Company as of December 31, audit provides a reasonable basis for our opinion. 2011 and 2010, and the related consolidated statements of in- A company’s internal control over financial reporting is a come, comprehensive income, changes in shareholders’ equity process designed to provide reasonable assurance regarding the and cash flows for each of the years in the three-year period reliability of financial reporting and the preparation of financial ended December 31, 2011, and our report dated February 3, statements for external purposes in accordance with generally ac- 2012 expressed an unqualified opinion on those consolidated cepted accounting principles. A company’s internal control over financial statements. KPMG LLP* Chartered Accountants Montreal, Canada February 3, 2012 * CA Auditor permit no. 10892 KPMG LLP is a Canadian limited liability partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. KPMG Canada provides services to KPMG LLP. 50 2011 Annual Report U.S. GAAP Canadian National Railway Company Consolidated Statement of Income In millions, except per share data Year ended December 31, 2011 2010 2009 Revenues Operating expenses Labor and fringe benefits Purchased services and material Fuel Depreciation and amortization Equipment rents Casualty and other Total operating expenses Operating income Interest expense Other income (Note 13) Income before income taxes Income tax expense (Note 14) Net income Earnings per share (Note 16) Basic Diluted Weighted-average number of shares Basic Diluted $ 9,028 $ 8,297 $ 7,367 1,812 1,744 1,696 1,120 1,036 1,027 1,412 1,048 884 228 276 834 243 368 820 790 284 344 5,732 5,273 4,961 3,296 3,024 2,406 (341) 401 (360) 212 (412) 267 3,356 2,876 2,261 (899) (772) (407) $ 2,457 $ 2,104 $ 1,854 $ 5.45 $ 4.51 $ 3.95 $ 5.41 $ 4.48 $ 3.92 451.1 466.3 469.2 454.4 470.1 473.5 See accompanying notes to consolidated financial statements. Canadian National Railway Company U.S. GAAP 2011 Annual Report 51 Consolidated Statement of Comprehensive Income In millions Net income Other comprehensive income (loss) (Note 19) Foreign exchange gain (loss) on: Year ended December 31, 2011 2010 2009 $ 2,457 $ 2,104 $ 1,854 Translation of the net investment in foreign operations 130 (330) (998) Translation of US dollar-denominated long-term debt designated as a hedge of the net investment in U.S. subsidiaries (122) 315 976 Pension and other postretirement benefit plans (Note 12): Net actuarial loss arising during the year Prior service cost arising during the year Amortization of net actuarial loss included in net periodic benefit cost (income) Amortization of prior service cost included in net periodic benefit cost (income) Derivative instruments (Note 18) Other comprehensive loss before income taxes Income tax recovery Other comprehensive loss Comprehensive income (1,541) (931) (28) 8 4 (2) (1,551) 421 (1,130) (5) 1 2 (1) (949) 188 (761) (868) (2) 2 5 - (885) 92 (793) $ 1,327 $ 1,343 $ 1,061 See accompanying notes to consolidated financial statements. 52 2011 Annual Report U.S. GAAP Canadian National Railway Company Consolidated Balance Sheet In millions Assets Current assets Cash and cash equivalents Restricted cash and cash equivalents (Note 9) Accounts receivable (Note 4) Material and supplies Deferred and receivable income taxes (Note 14) Other Total current assets Properties (Note 5) Intangible and other assets (Note 6) Total assets Liabilities and shareholders’ equity Current liabilities Accounts payable and other (Note 7) Current portion of long-term debt (Note 9) Total current liabilities Deferred income taxes (Note 14) Pension and other postretirement benefits, net of current portion (Note 12) Other liabilities and deferred credits (Note 8) Long-term debt (Note 9) Shareholders’ equity Common shares (Note 10) Accumulated other comprehensive loss (Note 19) Retained earnings Total shareholders’ equity Total liabilities and shareholders’ equity On behalf of the Board: David G. A. McLean Director Claude Mongeau Director December 31, 2011 2010 $ 101 $ 490 499 820 201 122 105 - 775 210 53 62 1,848 1,590 23,917 22,917 261 699 $ 26,026 $ 25,206 $ 1,580 $ 1,366 135 1,715 5,333 1,095 762 6,441 540 1,906 5,152 510 823 5,531 4,141 4,252 (2,839) (1,709) 9,378 8,741 10,680 11,284 $ 26,026 $ 25,206 See accompanying notes to consolidated financial statements. Canadian National Railway Company U.S. GAAP 2011 Annual Report 53 Consolidated Statement of Changes in Shareholders’ Equity In millions Issued and outstanding common shares Accumulated other Common comprehensive loss shares Retained earnings Total shareholders’ equity Balances at December 31, 2008 468.2 $ 4,179 $ (155) $ 6,535 $ 10,559 Net income Stock options exercised and other (Notes 10, 11) Other comprehensive loss (Note 19) Dividends ($1.01 per share) - 2.8 - - - 87 - - - - (793) - 1,854 1,854 - - (474) 87 (793) (474) Balances at December 31, 2009 471.0 4,266 (948) 7,915 11,233 Net income Stock options exercised and other (Notes 10, 11) Share repurchase program (Note 10) Other comprehensive loss (Note 19) Dividends ($1.08 per share) - 3.4 (15.0) - - - 124 (138) - - - - - (761) - 2,104 2,104 - (775) - (503) 124 (913) (761) (503) Balances at December 31, 2010 459.4 4,252 (1,709) 8,741 11,284 Net income Stock options exercised and other (Notes 10, 11) Share repurchase programs (Note 10) Other comprehensive loss (Note 19) Dividends ($1.30 per share) - 2.6 (19.9) - - - 74 (185) - - - - - (1,130) - 2,457 - (1,235) - (585) 2,457 74 (1,420) (1,130) (585) Balances at December 31, 2011 442.1 $ 4,141 $ (2,839) $ 9,378 $ 10,680 See accompanying notes to consolidated financial statements. 54 2011 Annual Report U.S. GAAP Canadian National Railway Company Consolidated Statement of Cash Flows In millions Operating activities Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Deferred income taxes (Note 14) Gain on disposal of property (Notes 5, 13) Changes in operating assets and liabilities: Accounts receivable Material and supplies Accounts payable and other Other current assets Other, net Year ended December 31, 2011 2010 2009 $ 2,457 $ 2,104 $ 1,854 884 531 834 418 (348) (152) (51) 11 34 (2) (3) (43) 285 13 (540) (457) 790 138 (226) 39 32 (204) 77 (221) Net cash provided by operating activities 2,976 2,999 2,279 Investing activities Property additions Acquisition, net of cash acquired (Note 3) Disposal of property (Note 5) Change in restricted cash and cash equivalents Other, net Net cash used in investing activities Financing activities Issuance of debt Repayment of debt Issuance of common shares due to exercise of stock options and related excess tax benefits realized (Note 11) Repurchase of common shares (Note 10) Dividends paid Net cash used in financing activities Effect of foreign exchange fluctuations on US dollar-denominated cash and cash equivalents Net increase (decrease) in cash and cash equivalents Cash and cash equivalents, beginning of year Cash and cash equivalents, end of year Supplemental cash flow information Net cash receipts from customers and other Net cash payments for: (1,625) (1,586) (1,402) - 369 (499) 26 - 168 - 35 (373) 231 - 107 (1,729) (1,383) (1,437) 1,361 - 1,626 (1,083) (184) (2,109) 77 (1,420) (585) 115 (913) (503) (1,650) (1,485) 14 (389) 490 7 138 352 73 - (474) (884) (19) (61) 413 $ 101 $ 490 $ 352 $ 8,995 $ 8,404 $ 7,505 Employee services, suppliers and other expenses (4,643) (4,334) (4,323) Interest Personal injury and other claims (Note 17) Pensions (Note 12) Income taxes (Note 14) Net cash provided by operating activities See accompanying notes to consolidated financial statements. (329) (97) (468) (482) (366) (64) (427) (214) (407) (112) (139) (245) $ 2,976 $ 2,999 $ 2,279 Canadian National Railway Company U.S. GAAP 2011 Annual Report 55 Notes to Consolidated Financial Statements Canadian National Railway Company, together with its wholly-owned subsidiaries, collectively “CN” or “the Company,” is engaged in the rail and related transportation business. CN spans Canada and mid-America, from the Atlantic and Pacific oceans to the Gulf of Mexico, serving the ports of Vancouver, Prince Rupert, B.C., Montreal, Halifax, New Orleans and Mobile, Alabama, and the key cities of Toronto, Buffalo, Chicago, Detroit, Duluth, Minnesota/Superior, Wisconsin, Green Bay, Wisconsin, Minneapolis/St. Paul, Memphis, St. Louis, and Jackson, Mississippi, with connections to all points in North America. CN’s freight revenues are derived from the movement of a diversified and balanced portfolio of goods, including petroleum and chemicals, grain and fertilizers, coal, metals and minerals, forest products, intermodal and automotive. 1 Summary of significant accounting policies Other comprehensive income (loss) (see Note 19 - Accumulated other comprehensive loss). These consolidated financial statements are expressed in The Company designates the US dollar-denominated long- Canadian dollars, except where otherwise indicated, and have term debt of the parent company as a foreign currency hedge been prepared in accordance with United States generally accept- of its net investment in U.S. subsidiaries. Accordingly, foreign ex- ed accounting principles (U.S. GAAP). The preparation of finan- change gains and losses, from the dates of designation, on the cial statements in conformity with generally accepted accounting translation of the US dollar-denominated long-term debt are also principles requires management to make estimates and assump- included in Other comprehensive income (loss). tions that affect the reported amounts of revenues and expenses during the period, the reported amounts of assets and liabilities, D. Cash and cash equivalents and the disclosure of contingent assets and liabilities at the date Cash and cash equivalents include highly liquid investments pur- of the financial statements. On an ongoing basis, management chased three months or less from maturity and are stated at cost, reviews its estimates, including those related to personal injury which approximates market value. and other claims, environmental matters, depreciation, pensions and other postretirement benefits, and income taxes, based upon E. Restricted cash and cash equivalents currently available information. Actual results could differ from The Company has the option, under its bilateral letter of credit these estimates. A. Principles of consolidation facility agreements with various banks, to pledge collateral in the form of cash and cash equivalents for a minimum term of three months, equal to at least the face value of the letters of credit is- These consolidated financial statements include the accounts of sued. Restricted cash and cash equivalents are shown separately all subsidiaries. The Company’s investments in which it has signifi- on the balance sheet and include highly liquid investments pur- cant influence are accounted for using the equity method and all chased three months or less from maturity and are stated at cost, other investments are accounted for using the cost method. which approximates market value. B. Revenues F. Accounts receivable Freight revenues are recognized using the percentage of com- Accounts receivable are recorded at cost net of billing adjustments pleted service method based on the transit time of freight as it and an allowance for doubtful accounts. The allowance for doubtful moves from origin to destination. The allocation of revenues be- accounts is based on expected collectability and considers historical tween reporting periods is based on the relative transit time in experience as well as known trends or uncertainties related to ac- each period with expenses being recorded as incurred. Revenues count collectability. When a receivable is deemed uncollectible, it is related to non-rail transportation services are recognized as ser- written off against the allowance for doubtful accounts. Subsequent vice is performed or as contractual obligations are met. Revenues recoveries of amounts previously written off are credited to the bad are presented net of taxes collected from customers and remitted debt expense in the Consolidated Statement of Income. to governmental authorities. G. Material and supplies C. Foreign currency Material and supplies, which consist mainly of rail, ties, and other All of the Company’s United States (U.S.) operations are self- items for construction and maintenance of property and equip- contained foreign entities with the US dollar as their functional ment, as well as diesel fuel, are valued at weighted-average cost. currency. Accordingly, the U.S. operations’ assets and liabilities are translated into Canadian dollars at the rate in effect at the H. Properties balance sheet date and the revenues and expenses are translated Railroad properties are carried at cost less accumulated depre- at average exchange rates during the year. All adjustments result- ciation including asset impairment write-downs. Labor, materials ing from the translation of the foreign operations are recorded in and other costs associated with the installation of rail, ties, ballast 56 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements and other structures are capitalized to the extent they meet the J. Pensions Company’s capitalization criteria. Major overhauls and large refur- Pension costs are determined using actuarial methods. Net peri- bishments of equipment are also capitalized when they result in odic benefit cost is charged to income and includes: an extension to the service life or increase the functionality of the (i) the cost of pension benefits provided in exchange for employ- asset. Repair and maintenance costs are expensed as incurred. ees’ services rendered during the year; The cost of properties, including those under capital leases, (ii) the interest cost of pension obligations; net of asset impairment write-downs, is depreciated on a straight- (iii) the expected long-term return on pension fund assets; line basis over their estimated service lives, measured in years, ex- (iv) the amortization of prior service costs and amendments over cept for rail which is measured in millions of gross tons per mile. the expected average remaining service life of the employee The Company follows the group method of depreciation whereby group covered by the plans; and a single composite depreciation rate is applied to the gross invest- (v) the amortization of cumulative net actuarial gains and losses ment in a class of similar assets, despite small differences in the in excess of 10% of the greater of the beginning of year bal- service life or salvage value of individual property units within the ances of the projected benefit obligation or market-related same asset class. value of plan assets, over the expected average remaining ser- In accordance with the group method of depreciation, upon vice life of the employee group covered by the plans. sale or retirement of properties in the normal course of business, cost less net salvage value is charged to accumulated deprecia- The pension plans are funded through contributions deter- tion. As a result, no gain or loss is recognized in income under the mined in accordance with the projected unit credit actuarial cost group method as it is assumed that the assets within the group method. on average have the same life and characteristics and therefore that gains or losses offset over time. For retirements of depre- K. Postretirement benefits other than pensions ciable properties that do not occur in the normal course of busi- The Company accrues the cost of postretirement benefits other ness, a gain or loss may be recognized if the retirement varies than pensions using actuarial methods. These benefits, which significantly from the retirement pattern identified through depre- are funded as they become due, include life insurance programs, ciation studies. A gain or loss is recognized in Other income for medical benefits and, for a closed group of employees, free rail the sale of land or disposal of assets that are not part of railroad travel benefits. operations. The Company amortizes the cumulative net actuarial gains Assets held for sale are measured at the lower of their carrying and losses in excess of 10% of the projected benefit obligation at amount or fair value, less cost to sell. Losses resulting from signifi- the beginning of the year, over the expected average remaining cant rail line sales are recognized in income when the asset meets service life of the employee group covered by the plan. the criteria for classification as held for sale, whereas losses result- ing from significant rail line abandonments are recognized in the L. Personal injury and other claims statement of income when the asset ceases to be used. Gains are In Canada, the Company accounts for costs related to employee recognized in income when they are realized. work-related injuries based on actuarially developed estimates of The Company reviews the carrying amounts of properties held the ultimate cost associated with such injuries, including compen- and used whenever events or changes in circumstances indicate sation, health care and third-party administration costs. that such carrying amounts may not be recoverable based on fu- In the U.S., the Company accrues the expected cost for per- ture undiscounted cash flows. Assets that are deemed impaired sonal injury, property damage and occupational disease claims, as a result of such review are recorded at the lower of carrying based on actuarial estimates of their ultimate cost. amount or fair value. I. Intangible assets For all other legal actions in Canada and the U.S., the Company maintains, and regularly updates on a case-by-case basis, pro- Intangible assets consist mainly of customer contracts and rela- visions for such items when the expected loss is both probable tionships assumed through past acquisitions and are being amor- and can be reasonably estimated based on currently available tized on a straight-line basis over 40 to 50 years. information. The Company reviews the carrying amounts of intangible as- sets held and used whenever events or changes in circumstanc- M. Environmental expenditures es indicate that such carrying amounts may not be recoverable Environmental expenditures that relate to current operations, based on future undiscounted cash flows. Assets that are deemed or to an existing condition caused by past operations, are ex- impaired as a result of such review are recorded at the lower of pensed unless they can contribute to current or future operations. carrying amount or fair value. Environmental liabilities are recorded when environmental assess- ments occur, remedial efforts are probable, and when the costs, Canadian National Railway Company U.S. GAAP 2011 Annual Report 57 Notes to Consolidated Financial Statements 1 Summary of significant accounting policies continued Q. Recent accounting pronouncement The Accounting Standards Board of the Canadian Institute of Chartered Accountants requires all publicly accountable enterprises based on a specific plan of action in terms of the technology to to report under International Financial Reporting Standards (IFRS) be used and the extent of the corrective action required, can be for the fiscal years beginning on or after January 1, 2011. However, reasonably estimated. The Company accrues its allocable share of National Instrument 52-107 issued by the Ontario Securities liability taking into account the Company’s alleged responsibility, Commission allows Securities and Exchange Commission (SEC) is- the number of potentially responsible parties and their ability to suers, as defined by the U.S. Securities and Exchange Commission, pay their respective shares of the liability. Recoveries of environ- such as CN, to file with Canadian securities regulators financial mental remediation costs from other parties are recorded as as- statements prepared in accordance with U.S. GAAP. As such, the sets when their receipt is deemed probable and collectability is Company has decided not to report under IFRS by 2011 and to reasonably assured. N. Income taxes continue reporting under U.S. GAAP. The SEC has issued a road- map for the potential convergence to IFRS for U.S. issuers. Should the SEC decide it will move forward with the convergence to IFRS, The Company follows the asset and liability method of account- the Company will convert its reporting to IFRS at that time. ing for income taxes. Under the asset and liability method, the change in the net deferred tax asset or liability is included in the computation of net income or Other comprehensive income 2 Accounting changes (loss). Deferred tax assets and liabilities are measured using en- acted tax rates expected to apply to taxable income in the years 2011 in which temporary differences are expected to be recovered or In June 2011, the Financial Accounting Standards Board (FASB) is- settled. O. Derivative financial instruments sued Accounting Standards Update (ASU) 2011-05, Presentation of Comprehensive Income, giving companies the option to present the components of net income and comprehensive in- The Company uses derivative financial instruments from time to come in either one or two consecutive financial statements. time in the management of its interest rate and foreign currency ASU 2011-05 eliminates the option to present the components exposures. Derivative instruments are recorded on the balance of other comprehensive income in the statement of changes in sheet at fair value and the changes in fair value are recorded in shareholders’ equity. ASU 2011-05 also requires reclassification net income or Other comprehensive income (loss) depending on adjustments for each component of accumulated other com- the nature and effectiveness of the hedge transaction. Income prehensive income (AOCI) in both net income and other com- and expense related to hedged derivative financial instruments prehensive income (OCI) to be separately disclosed on the face are recorded in the same category as that generated by the un- of the financial statements. In December 2011, the FASB issued derlying asset or liability. P. Stock-based compensation ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income, which deferred the effective date The Company follows the fair value based approach for stock op- to present reclassification adjustments in net income. The effec- tion awards based on the grant-date fair value using the Black- tive date of the deferral is consistent with the effective date of Scholes option-pricing model. The Company expenses the fair ASU 2011-05 which becomes effective for fiscal years beginning value of its stock option awards on a straight-line basis, over the on or after December 15, 2011. During the deferral period, the period during which an employee is required to provide service FASB plans to re-evaluate the requirement, with a final decision (requisite service period) or until retirement eligibility is attained, expected in 2012. whichever is shorter. The Company also follows the fair value based approach for cash settled awards using a lattice-based The Company currently presents the components of net income valuation model. Compensation cost for cash settled awards is and other comprehensive income in two separate and consecu- based on the fair value of the awards at period-end and is rec- tive financial statements. As such, the Company does not expect ognized over the period during which an employee is required to any significant changes to its annual consolidated financial state- provide service (requisite service period) or until retirement eligi- ments from implementation of the new standards. bility is attained, whichever is shorter. See Note 11 - Stock plans, for the assumptions used to determine fair value and for other 2010 required disclosures. Accounting standard updates effective in 2010 that were issued by the FASB had no significant impact on the Company’s consoli- dated financial statements. 58 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements 2009 Business Combinations The following table summarizes the consideration paid for EJ&E and the fair value of the assets acquired and liabilities as- On January 1, 2009, the Company adopted the new require- sumed that were recognized at the acquisition date: ments of the FASB Accounting Standards Codification (ASC) 805, “Business Combinations,” relating to the accounting for busi- ness combinations (previously Statement of Financial Accounting Standards (SFAS) No. 141 (R)), which became effective for acqui- sitions with an acquisition date on or after the beginning of the first annual reporting period beginning on or after December 15, 2008. Until December 31, 2008, the Company was subject to the requirements of SFAS No. 141, “Business Combinations,” which required that acquisition-related costs be included as part of the purchase cost of an acquired business. As such, the Company had reported acquisition-related costs in Other current assets pending the closing of its acquisition of the Elgin, Joliet In US millions Consideration Cash Fair value of total consideration transferred Recognized amounts of identifiable assets acquired and liabilities assumed Current assets Properties Current liabilities Other noncurrent liabilities Total identifiable net assets At January 31, 2009 $ 300 $ 300 $ 4 310 (4) (10) $ 300 and Eastern Railway Company (EJ&E), which had been subject The 2009 revenues and net income of EJ&E included in the to an extensive U.S. Surface Transportation Board (STB) approval Company’s Consolidated Statement of Income from the ac- process. On January 31, 2009, the Company completed its ac- quisition date to December 31, 2009, were $74 million and quisition of the EJ&E and accounted for the acquisition under $12 million, respectively. the revised standard. The Company incurred acquisition-relat- ed costs, including costs to obtain regulatory approval of ap- proximately $49 million, which were expensed and reported in 4 Accounts receivable Casualty and other in the Consolidated Statement of Income for the year ended December 31, 2009 pursuant to FASB ASC 805 requirements. At the time of adoption, this change in account- ing policy had the effect of decreasing net income by $28 mil- lion ($0.06 per basic or diluted earnings per share) and Other current assets by $46 million. This change had no effect on the Consolidated Statement of Cash Flows. Disclosures prescribed by FASB ASC 805 are presented in Note 3 - Acquisition. 3 Acquisition 2009 In millions Freight Non-freight Gross accounts receivable Allowance for doubtful accounts Net accounts receivable December 31, 2011 2010 $ 630 $ 585 206 211 836 796 (16) (21) $ 820 $ 775 The Company had a five-year agreement to sell an undivided co-ownership interest in a revolving pool of freight receivables to an unrelated trust for maximum cash proceeds of $600 million. The agreement expired on May 31, 2011 and was not renewed. As at December 31, 2010, the Company had no receivables sold under On January 31, 2009, the Company acquired the principal rail lines this program. of the EJ&E, a short-line railway that operated over 198 miles of track in and around Chicago, for a total cash consideration of US$300 mil- lion (C$373 million), paid with cash on hand. The Company ac- counted for the acquisition using the acquisition method of account- ing pursuant to FASB ASC 805, “Business Combinations,” which the Company adopted on January 1, 2009. As such, the consolidated financial statements of the Company include the assets, liabilities and results of operations of EJ&E as of January 31, 2009, the date of acquisition. The costs incurred to acquire the EJ&E of approximately $49 million were expensed and reported in Casualty and other in the Consolidated Statement of Income for the year ended December 31, 2009 (see Note 2 - Accounting changes). Canadian National Railway Company U.S. GAAP 2011 Annual Report 59 Notes to Consolidated Financial Statements 5 Properties In millions Track and roadway (1) Rolling stock Buildings Information technology (2) Other 2011 depreciation rate Accumulated Cost depreciation Net December 31, 2011 December 31, 2010 Accumulated depreciation Cost Net 2% 4% 2% 12% 6% $ 25,534 $ 6,903 $ 18,631 $ 24,568 $ 6,744 $ 17,824 4,923 1,220 931 1,213 1,668 3,255 473 383 477 747 548 736 4,843 1,148 854 1,057 1,565 3,278 467 330 447 681 524 610 Total properties including capital leases $ 33,821 $ 9,904 $ 23,917 $ 32,470 $ 9,553 $ 22,917 Capital leases included in properties Track and roadway (3) $ 417 $ 48 $ 369 $ 427 $ 43 $ 384 Rolling stock Buildings Other 1,144 109 102 317 16 15 827 93 87 1,129 108 130 287 13 28 842 95 102 Total capital leases included in properties $ 1,772 $ 396 $ 1,376 $ 1,794 $ 371 $ 1,423 (1) Includes the cost of land of $1,798 million and $1,712 million as at December 31, 2011 and 2010, respectively. (2) The Company capitalized $94 million in 2011 and $79 million in 2010 of internally developed software costs pursuant to ASC 350-40, “Intangibles - Goodwill and Other, Internal - Use Software.” (3) Includes $108 million of right-of-way access in both years. Accounting policy for capitalization of costs • Rail and related track material: installation of 39 or more The Company’s railroad operations are highly capital intensive. continuous feet of rail; The Company’s properties consist mainly of a large base of ho- • Ties: installation of 5 or more ties per 39 feet; mogeneous or network-type assets such as rail, ties, ballast and • Ballast: installation of 171 cubic yards of ballast per mile. other structures, which form the Company’s Track and roadway properties, and rolling stock. The Company’s capital expenditures Expenditures relating to the Company’s properties that do not are for the replacement of assets and for the purchase or con- meet the Company’s capitalization criteria are considered normal struction of assets to enhance operations or provide new service repairs and maintenance and are expensed. For Track and road- offerings to customers. A large portion of the Company’s capi- way properties, such expenditures include but are not limited to tal expenditures are for self-constructed properties including the spot tie replacement, spot or broken rail replacement, physical replacement of existing track and roadway assets and track line track inspection for detection of rail defects and minor track cor- expansion, as well as major overhauls and large refurbishments rections, and other general maintenance of track infrastructure. of rolling stock. For the ballast asset, the Company also engages in “shoulder Expenditures are generally capitalized if they extend the life ballast undercutting” that consists of removing some or all of the of the asset or provide future benefits such as increased revenue- ballast, which has deteriorated over its service life, and replacing generating capacity, functionality, or physical or service capacity. it with new ballast. When ballast is installed as part of a shoulder The Company has a process in place to determine whether its ballast undercutting project, it represents the addition of a new capital programs qualify for capitalization. For Track and road- asset and not the repair or maintenance of an existing asset. As way properties, the Company establishes basic capital programs such, the Company capitalizes expenditures related to shoulder to replace or upgrade the track infrastructure assets which are ballast undercutting given that an existing asset is retired and re- capitalized if they meet the capitalization criteria. These basic placed with a new asset. Under the group method of account- capital programs are planned in advance and carried out by the ing for properties, the deteriorated ballast is retired at its average Company’s engineering work force. cost measured using the quantities of new ballast added. In addition, for Track and roadway properties, expendi- For purchased assets, the Company capitalizes all costs neces- tures that meet the minimum level of activity as defined by the sary to make the asset ready for its intended use. Expenditures Company are also capitalized as detailed below: that are capitalized as part of self-constructed properties include • Land: all purchases of land; direct material, labor, and contracted services, as well as other • Grading: installation of road bed, retaining walls, allocated costs which are not charged directly to capital projects. drainage structures; These allocated costs include, but are not limited to, fringe ben- efits, small tools and supplies, machinery used on projects and 60 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements project supervision. The Company reviews and adjusts its alloca- incrementally as rail grinding is performed thereon. As such, the tions, as required, to reflect the actual costs incurred each year. costs incurred for rail grinding are capitalized given that the ac- Costs of deconstruction and removal of replaced assets, re- tivity extends the service life of the rail asset beyond its original ferred to herein as dismantling costs, are distinguished from or current condition as additional gross tons can be carried over installation costs for self-constructed properties based on the the rail for its remaining service life. The Company amortizes nature of the related activity. For Track and roadway properties, the cost of rail grinding over the remaining life of the rail asset, employees concurrently perform dismantling and installation of which includes the incremental life extension generated by the new track and roadway assets and, as such, the Company esti- rail grinding. mates the amount of labor and other costs that are related to dismantling. The Company determines dismantling costs based Disposal of property on an analysis of the track and roadway installation process. 2011 IC RailMarine Terminal Accounting policy for depreciation In August 2011, the Company sold substantially all of the as- Properties are carried at cost less accumulated depreciation in- sets of IC RailMarine Terminal Company (ICRMT), an indirect cluding asset impairment write-downs. The cost of properties, subsidiary of the Company, to Raven Energy, LLC, an affiliate of including those under capital leases, net of asset impairment Foresight Energy, LLC (Foresight) and the Cline Group (Cline), write-downs, is depreciated on a straight-line basis over their es- for cash proceeds of $70 million (US$73 million) before transac- timated service lives, measured in years, except for rail which is tion costs. ICRMT is located on the east bank of the Mississippi measured in millions of gross tons per mile. The Company fol- River and stores and transfers bulk commodities and liquids be- lows the group method of depreciation whereby a single com- tween rail, ship and barge, serving customers in North American posite depreciation rate is applied to the gross investment in a and global markets. Under the sale agreement, the Company class of similar assets, despite small differences in the service life will benefit from a 10-year rail transportation agreement with or salvage value of individual property units within the same as- Savatran LLC, an affiliate of Foresight and Cline, to haul a set class. The Company uses approximately 40 different depre- minimum annual volume of coal from four Illinois mines to the ciable asset classes. ICRMT transfer facility. The transaction resulted in a gain on dis- For all depreciable assets, the depreciation rate is based on posal of $60 million ($38 million after-tax) that was recorded in the estimated service lives of the assets. Assessing the reason- Other income. ableness of the estimated service lives of properties requires judgment and is based on currently available information, includ- Lakeshore East ing periodic depreciation studies conducted by the Company. In March 2011, the Company entered into an agreement with The Company’s U.S. properties are subject to comprehensive Metrolinx to sell a segment of the Kingston subdivision known depreciation studies as required by the STB and are conducted as the Lakeshore East in Pickering and Toronto, Ontario, together by external experts. Depreciation studies for Canadian properties with the rail fixtures and certain passenger agreements (collec- are not required by regulation and are therefore conducted in- tively the “Lakeshore East”), for cash proceeds of $299 million ternally. Studies are performed on specific asset groups on a pe- before transaction costs. Under the agreement, the Company riodic basis. Changes in the estimated service lives of the assets obtained the perpetual right to operate freight trains over the and their related composite depreciation rates are implemented Lakeshore East at its then current level of operating activity, with prospectively. the possibility of increasing its operating activity for additional For the rail asset, the estimated service life is measured in mil- consideration. The transaction resulted in a gain on disposal of lions of gross tons per mile and varies based on rail characteris- $288 million ($254 million after-tax) that was recorded in Other tics such as weight, curvature and metallurgy. The annual com- income under the full accrual method of accounting for real es- posite depreciation rate for rail assets is determined by dividing tate transactions. the estimated annual number of gross tons carried over the rail by the estimated service life of the rail measured in millions of 2010 gross tons per mile. For the rail asset, the Company capitalizes Oakville subdivision the costs of rail grinding which consists of restoring and improv- In March 2010, the Company entered into an agreement with ing the rail profile and removing irregularities from worn rail to Metrolinx to sell a portion of the property known as the Oakville extend the service life. The service life of the rail asset is based subdivision in Toronto, Ontario, together with the rail fixtures on expected future usage of the rail in its existing condition, de- and certain passenger agreements (collectively the “Oakville sub- termined using railroad industry research and testing, less the rail division”), for proceeds of $168 million before transaction costs, asset’s usage to date. The service life of the rail asset is increased of which $24 million was placed in escrow at the time of disposal Canadian National Railway Company U.S. GAAP 2011 Annual Report 61 Notes to Consolidated Financial Statements 5 Properties continued 6 Intangible and other assets and was entirely released by December 31, 2010 in accordance In millions December 31, 2011 2010 with the terms of the agreement. Under the agreement, the Deferred and long-term receivables $ 98 $ 101 Company obtained the perpetual right to operate freight trains over the Oakville subdivision at its then current level of operating Intangible assets (A) Investments (B) activity, with the possibility of increasing its operating activity for Pension asset (Note 12) additional consideration. The transaction resulted in a gain on Other 54 31 - 78 54 25 442 77 disposal of $152 million ($131 million after-tax) that was record- Total intangible and other assets $ 261 $ 699 ed in Other income under the full accrual method of accounting for real estate transactions. 2009 Lower Newmarket subdivision In November 2009, the Company entered into an agree- ment with Metrolinx to sell the property known as the Lower Newmarket subdivision in Vaughan and Toronto, Ontario, to- gether with the rail fixtures and certain passenger agreements (collectively the “Lower Newmarket subdivision”), for cash pro- ceeds of $71 million before transaction costs. Under the agree- ment, the Company obtained the perpetual right to operate freight trains over the Lower Newmarket subdivision at its then current level of operating activity, with the possibility of increas- ing its operating activity for additional consideration. The trans- action resulted in a gain on disposal of $69 million ($59 million after-tax) that was recorded in Other income under the full ac- crual method of accounting for real estate transactions. Weston subdivision In March 2009, the Company entered into an agreement with GO Transit to sell the property known as the Weston subdivision in Toronto, Ontario, together with the rail fixtures and certain passenger agreements (collectively the “Weston subdivision”), for cash proceeds of $160 million before transaction costs, of which $50 million placed in escrow at the time of disposal was entirely released by December 31, 2009 in accordance with the terms of the agreement. Under the agreement, the Company obtained the perpetual right to operate freight trains over the A. Intangible assets Intangible assets consist mainly of customer contracts and rela- tionships assumed through past acquisitions. B. Investments As at December 31, 2011, the Company had $21 million ($21 mil- lion as at December 31, 2010) of investments accounted for under the equity method and $10 million ($4 million as at December 31, 2010) of investments accounted for under the cost method. 7 Accounts payable and other In millions Trade payables Payroll-related accruals Income and other taxes Accrued interest Accrued charges December 31, 2011 2010 $ 445 $ 383 343 130 123 121 84 84 63 18 292 170 104 97 83 37 34 18 Personal injury and other claims provisions (Note 17) Stock-based incentives liability (Note 11) Environmental provisions (Note 17) Other postretirement benefits liability (Note 12) Other Total accounts payable and other 169 148 $ 1,580 $ 1,366 Weston subdivision at its then current level of operating activity, 8 Other liabilities and deferred credits with the possibility of increasing its operating activity for addi- tional consideration. The transaction resulted in a gain on dis- posal of $157 million ($135 million after-tax) that was recorded in Other income under the full accrual method of accounting for real estate transactions. In millions December 31, 2011 2010 Personal injury and other claims provisions, net of current portion (Note 17) Stock-based incentives liability, net of current portion (Note 11) Environmental provisions, net of current portion (Note 17) Deferred credits and other Total other liabilities and deferred credits $ 226 $ 263 180 162 89 116 267 282 $ 762 $ 823 62 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements 9 Long-term debt In millions Debentures and notes: (A) Canadian National series: 6.38% 10-year notes (B) 4.40% 10-year notes (B) 4.95% 6-year notes (B) 5.80% 10-year notes (B) 1.45% 5-year notes (B) 5.85% 10-year notes (B) 5.55% 10-year notes (B) 6.80% 20-year notes (B) 5.55% 10-year notes (B) 2.85% 10-year notes (B) 7.63% 30-year debentures 6.90% 30-year notes (B) 7.38% 30-year debentures (B) 6.25% 30-year notes (B) 6.20% 30-year notes (B) 6.71% Puttable Reset Securities PURSSM (B) 6.38% 30-year debentures (B) Illinois Central series: 5.00% 99-year income debentures 7.70% 100-year debentures Outstanding US dollar- denominated amount Maturity December 31, 2011 2010 Oct. 15, 2011 $ - $ - $ 398 Mar. 15, 2013 Jan. 15, 2014 June 1, 2016 Dec. 15, 2016 Nov. 15, 2017 May 15, 2018 July 15, 2018 Mar. 1, 2019 Dec. 15, 2021 May 15, 2023 July 15, 2028 Oct. 15, 2031 Aug. 1, 2034 June 1, 2036 July 15, 2036 Nov. 15, 2037 Dec. 1, 2056 Sep. 15, 2096 400 325 250 300 250 325 200 550 400 150 475 200 500 450 250 300 7 125 407 331 254 305 254 331 203 559 407 153 483 203 509 458 254 305 7 127 398 323 249 - 249 323 199 547 - 149 472 199 497 448 249 298 7 124 Total US dollar-denominated debentures and notes $ 5,457 5,550 5,129 BC Rail series: Non-interest bearing 90-year subordinated notes (C) July 14, 2094 842 842 Total debentures and notes Other: Commercial paper (G) (H) Capital lease obligations and other (D) Total debt, gross Less: Net unamortized discount Total debt (E) (1) Less: Current portion of long-term debt (E) Total long-term debt (1) See Note 18 - Financial Instruments, for the fair value of debt. 6,392 5,971 82 957 - 952 7,431 6,923 855 852 6,576 6,071 135 540 $ 6,441 $ 5,531 Footnotes to the table follow on the next page. Canadian National Railway Company U.S. GAAP 2011 Annual Report 63 Notes to Consolidated Financial Statements 9 Long-term debt continued G. In May 2011, the Company entered into a $800 million four-year revolving credit facility agreement with a consortium A. The Company’s debentures, notes and revolving credit facility of lenders. The agreement allows for an increase in amount, are unsecured. up to a maximum of $500 million, as well as the option to ex- tend the term by an additional year at each anniversary date, B. These debt securities are redeemable, in whole or in part, at subject to the consent of individual lenders. The credit facility, the option of the Company, at any time, at the greater of par containing customary terms and conditions, is available for gen- and a formula price based on interest rates prevailing at the time eral corporate purposes, including back-stopping the Company’s of redemption. commercial paper program, and provides for borrowings at various interest rates, including the Canadian prime rate, bank- C. The Company records these notes as a discounted debt of ers’ acceptance rates, the U.S. federal funds effective rate and $8 million, using an imputed interest rate of 5.75%. The dis- the London Interbank Offer Rate, plus applicable margins. The count of $834 million is included in the net unamortized credit facility agreement has one financial covenant, which limits discount. debt as a percentage of total capitalization, and with which the Company is in compliance. This facility replaces the US$1 billion D. During 2011, the Company recorded $87 million in assets it credit facility that was scheduled to expire in October 2011. As acquired through equipment leases ($132 million in 2010), for at December 31, 2011 and December 31, 2010, the Company which an equivalent amount was recorded in debt. had no outstanding borrowings under its revolving credit facility. Interest rates for capital lease obligations range from approxi- mately 0.7% to 11.8% with maturity dates in the years 2012 H. The Company has a commercial paper program, which is through 2037. The imputed interest on these leases amounted backed by its revolving credit facility, enabling it to issue com- to $299 million as at December 31, 2011 and $342 million as at mercial paper up to a maximum aggregate principal amount of December 31, 2010. $800 million, or the US dollar equivalent. As at December 31, The capital lease obligations are secured by properties with 2011, the Company had borrowings of $82 million (US$81 mil- a net carrying amount of $993 million as at December 31, 2011 lion) of commercial paper (nil as at December 31, 2010) which and $1,036 million as at December 31, 2010. were presented in Current portion of long-term debt on the Balance Sheet. The weighted-average interest rate on these bor- E. Long-term debt maturities, including repurchase arrange- rowings was 0.20%. ments and capital lease repayments on debt outstanding as at December 31, 2011, for the next five years and thereafter, are as I. In April 2011, the Company entered into a series of three- follows: In millions 2012 (1) 2013 2014 2015 2016 year bilateral letter of credit facility agreements with vari- ous banks to support its requirements to post letters of credit Debt Total in the ordinary course of business. As at December 31, 2011, Capital leases $ 53 $ 82 $ 135 from a total committed amount of $520 million by the various 108 209 81 269 404 328 - 557 512 537 81 826 banks, the Company had letters of credit drawn of $499 million ($436 million as at December 31, 2010, under its previous US$1 billion credit facility). Under these agreements, the Company has the option from time to time to pledge collateral in the form of cash or cash equivalents, for a minimum term of three months, 2017 and thereafter 235 4,250 4,485 (1) Current portion of long-term debt. $ 955 $ 5,621 $ 6,576 equal to at least the face value of the letters of credit issued. As at December 31, 2011, cash and cash equivalents of $499 mil- lion were pledged as collateral and recorded as Restricted cash F. The aggregate amount of debt payable in US currency as at and cash equivalents. December 31, 2011 was US$6,295 million (C$6,402 million), in- cluding US$757 million relating to capital leases and other, and US$5,914 million (C$5,882 million), including US$757 million re- lating to capital leases and other, as at December 31, 2010. 64 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements 10 Capital stock 11 Stock plans A. Authorized capital stock The Company has various stock-based incentive plans for eligible The authorized capital stock of the Company is as follows: employees. A description of the Company’s major plans is pro- • • Unlimited number of Common Shares, without par value vided below: Unlimited number of Class A Preferred Shares, without par value, issuable in series A. Employee Share Investment Plan • Unlimited number of Class B Preferred Shares, without par The Company has an Employee Share Investment Plan (ESIP) giv- value, issuable in series ing eligible employees the opportunity to subscribe for up to 10% of their gross salaries to purchase shares of the Company’s B. Issued and outstanding common shares common stock on the open market and to have the Company The following table provides the activity of the issued and out- invest, on the employees’ behalf, a further 35% of the amount standing common shares of the Company for the last three years invested by the employees, up to 6% of their gross salaries. ended December 31, 2011: In millions Year ended December 31, 2011 2010 2009 Issued and outstanding common shares at beginning of year 459.4 471.0 468.2 Number of shares repurchased through buyback programs Stock options exercised (19.9) (15.0) 2.6 3.4 - 2.8 Issued and outstanding common shares at end of year 442.1 459.4 471.0 Share repurchase programs In January 2011, the Board of Directors of the Company approved a share repurchase program which allowed for the repurchase of up to 16.5 million common shares to the end of December 2011 pursuant to a normal course issuer bid, at prevailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock Exchange. This share repurchase program was completed by September 30, 2011. In October 2011, the Board of Directors of the Company approved a new share repurchase program which allows for the repurchase of up to 17.0 million common shares between October 28, 2011 and October 27, 2012 pursuant to a normal course issuer bid at prevailing market prices plus brokerage fees, or such other prices as may be permitted by the Toronto Stock Exchange. The following table provides the activities under such share repurchase programs, as well as the share repurchase programs The following table provides the number of participants hold- ing shares, the total number of ESIP shares purchased on behalf of employees, including the Company’s contributions, as well as the resulting expense recorded for the years ended December 31, 2011, 2010 and 2009: Year ended December 31, 2011 2010 2009 Number of participants holding shares 16,218 14,997 14,152 Total number of ESIP shares purchased on behalf of employees (millions) 1.3 1.3 1.6 Expense for Company contribution (millions) $ 21 $ 19 $ 18 B. Stock-based compensation plans The following table provides the total stock-based compensa- tion expense for awards under all plans, as well as the related tax benefit recognized in income, for the years ended December 31, 2011, 2010 and 2009: In millions Year ended December 31, 2011 2010 2009 Cash settled awards Restricted share unit plan $ 81 $ 77 $ 43 Voluntary Incentive Deferral Plan Stock option awards 21 102 10 18 95 9 33 76 14 Total stock-based compensation expense $ 112 $ 104 $ 90 Tax benefit recognized in income $ 24 $ 27 $ 26 (i) Cash settled awards Restricted share units 2010 2009 The Company has granted restricted share units (RSUs), 0.5 mil- of the prior years: In millions, except per share data Year ended December 31, Number of common shares (1) 2011 19.9 Weighted-average price per share (2) $ 71.33 $ 60.86 Amount of repurchase $ 1,420 $ 913 15.0 - - - $ $ (1) Includes common shares purchased in the first and fourth quarters of 2011 and in the second and third quarters of 2010 pursuant to private agreements between the Company and arm’s-length third-party sellers. (2) Includes brokerage fees. lion in 2011, 0.5 million in 2010 and 0.9 million in 2009, to des- ignated management employees entitling them to receive payout in cash based on the Company’s share price. The RSUs granted are generally scheduled for payout after three years (“plan pe- riod”) and vest conditionally upon the attainment of a target re- lating to return on invested capital (ROIC) over the plan period. Such performance vesting criteria results in a performance vesting factor that ranges from 0% to 150% depending on the level of ROIC attained. Canadian National Railway Company U.S. GAAP 2011 Annual Report 65 Notes to Consolidated Financial Statements 11 Stock plans continued $18 million included in the above amount, to its former Chief Executive Officer (CEO) pending resolution with the former CEO Payout is conditional upon the attainment of a minimum of issues relating to his compliance with the non-compete, non- share price, calculated using the average of the last three months solicitation and non-disclosure of confidential information con- of the plan period. In addition, commencing at various dates, ditions contained in the former CEO’s employment agreement for senior and executive management employees (“executive and in respect of which the Company has commenced legal employees”), payout for RSUs is also conditional on compliance proceedings. with the conditions of their benefit plans, award or employment As at December 31, 2011, 0.2 million RSUs remained autho- agreements, including but not limited to non-compete, non-so- rized for future issuance under this plan. licitation and non-disclosure of confidential information condi- tions. Current or former executive employees who breach such Voluntary Incentive Deferral Plan conditions of their benefit plans, award or employment agree- The Company has a Voluntary Incentive Deferral Plan (VIDP), pro- ments will forfeit the RSU payout. Should the Company reason- viding eligible senior management employees the opportunity to ably determine that a current or former executive employee may elect to receive their annual incentive bonus payment and oth- have violated the conditions of their benefit plans, award or em- er eligible incentive payments in deferred share units (DSUs). A ployment agreement, the Company may at its discretion change DSU is equivalent to a common share of the Company and also the manner of vesting of the RSUs to suspend payout on any earns dividends when normal cash dividends are paid on com- RSUs pending resolution of such matter. mon shares. The number of DSUs received by each participant The value of the payout is equal to the number of RSUs is established using the average closing price for the 20 trading awarded multiplied by the performance vesting factor and by the days prior to and including the date of the incentive payment. 20-day average closing share price ending on January 31 of the For each participant, the Company will grant a further 25% of following year. On December 31, 2011, for the 2009 grant, the the amount elected in DSUs, which will vest over a period of level of ROIC attained resulted in a performance vesting factor of four years. The election to receive eligible incentive payments in approximately 120%. As the minimum share price condition was DSUs is no longer available to a participant when the value of met, payout under the plan of approximately $80 million, calcu- the participant’s vested DSUs is sufficient to meet the Company’s lated using the Company’s average share price during the 20-day stock ownership guidelines. The value of each participant’s DSUs period ending on January 31, 2012 and will be paid to employ- is payable in cash at the time of cessation of employment. The ees meeting the conditions of their benefit plans, award or em- Company’s liability for DSUs is marked-to-market at each period- ployment agreements in the first quarter of 2012. In addition, end based on the Company’s closing stock price. the Company has suspended the RSU payout of approximately The following table provides the 2011 activity for all cash settled awards: In millions Outstanding at December 31, 2010 Granted (Payout) Vested during year Outstanding at December 31, 2011 RSUs VIDP Nonvested Vested Nonvested Vested 1.3 0.5 (0.9) 0.9 0.7 (0.7) 0.9 0.9 - - - - 1.5 (0.1) - 1.4 66 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements The following table provides valuation and expense information for all cash settled awards: In millions, unless otherwise indicated RSUs (1) VIDP (2) Total Year of grant 2011 2010 2009 2008 2007 2006 Stock-based compensation expense (recovery) recognized over requisite service period Year ended December 31, 2011 $ 19 $ 27 $ 35 $ - N/A Year ended December 31, 2010 Year ended December 31, 2009 N/A N/A $ 17 $ 34 $ 26 $ - N/A $ 13 $ 3 $ 29 $ (2) $ 33 $ 76 Liability outstanding December 31, 2011 December 31, 2010 Fair value per unit December 31, 2011 ($) $ 19 $ 44 $ 82 N/A N/A $ 17 $ 46 $ 37 N/A N/A N/A N/A $ 119 $ 264 $ 99 $ 199 $ 60.48 $ 77.59 $ 80.15 N/A N/A N/A $ 80.15 N/A N/A N/A $ 21 $ 102 $ 18 $ 95 Fair value of awards vested during the year Year ended December 31, 2011 $ - $ - $ 82 N/A Year ended December 31, 2010 Year ended December 31, 2009 N/A N/A Nonvested awards at December 31, 2011 $ - $ - $ 37 N/A $ - $ - $ 38 N/A N/A N/A N/A N/A $ 1 $ 83 $ 1 $ 38 $ 3 $ 41 Unrecognized compensation cost $ 20 $ 14 $ - Remaining recognition period (years) 2.0 1.0 N/A N/A N/A N/A N/A N/A N/A $ 1 $ 35 N/A (3) N/A Assumptions (4) Stock price ($) $ 80.15 $ 80.15 $ 80.15 Expected stock price volatility (5) 18% 18% Expected term (years) (6) Risk-free interest rate (7) Dividend rate ($) (8) 2.0 1.0 0.95% 0.92% $ 1.30 $ 1.30 N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A $ 80.15 N/A N/A N/A N/A N/A N/A N/A N/A N/A (1) Compensation cost is based on the fair value of the awards at period-end using the lattice-based valuation model that uses the assumptions as presented herein. (2) Compensation cost is based on intrinsic value. (3) The remaining recognition period has not been quantified as it relates solely to the 25% Company grant and the dividends earned thereon, representing a minimal number of units. (4) Assumptions used to determine fair value are at December 31, 2011. (5) Based on the historical volatility of the Company’s stock over a period commensurate with the expected term of the award. (6) Represents the remaining period of time that awards are expected to be outstanding. (7) Based on the implied yield available on zero-coupon government issues with an equivalent term commensurate with the expected term of the awards. (8) Based on the annualized dividend rate. Canadian National Railway Company U.S. GAAP 2011 Annual Report 67 Notes to Consolidated Financial Statements 11 Stock plans continued (ii) Stock option awards Options issued by the Company include conventional op- tions, which vest over a period of time; and performance-ac- celerated stock options. As at December 31, 2011, the perfor- The Company has stock option plans for eligible employees to mance-accelerated stock options were fully vested. acquire common shares of the Company upon vesting at a price For 2011, 2010 and 2009, the Company granted 0.6 million, equal to the market value of the common shares at the date of 0.7 million and 1.2 million, respectively, of conventional stock granting. The options are exercisable during a period not exceed- options to designated senior management employees that vest ing 10 years. The right to exercise options generally accrues over over a period of four years of continuous employment. a period of four years of continuous employment. Options are not The total number of options outstanding at December 31, generally exercisable during the first 12 months after the date of 2011, for conventional and performance-accelerated options grant. At December 31, 2011, 11.0 million common shares re- was 5.3 million and 1.6 million, respectively. mained authorized for future issuances under these plans. The following table provides the activity of stock option awards during 2011, and for options outstanding and exercisable at December 31, 2011, the weighted-average exercise price. Outstanding at December 31, 2010 (1) Granted Exercised Vested Outstanding at December 31, 2011 (1) Exercisable at December 31, 2011 (1) Options outstanding Weighted- average exercise price Number of options In millions 8.9 0.6 (2.6) N/A 6.9 4.9 $ 34.23 $ 68.94 $ 26.94 N/A $ 40.80 $ 35.58 Nonvested options Weighted- Number of average grant options date fair value In millions 2.3 0.6 N/A (0.9) 2.0 N/A $ 12.80 $ 15.66 N/A $ 12.83 $ 13.71 N/A (1) Stock options with a US dollar exercise price have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. The following table provides the number of stock options outstanding and exercisable as at December 31, 2011 by range of exercise price and their related intrinsic value, and for options outstanding, the weighted-average years to expiration. The table also provides the aggregate intrinsic value for in-the-money stock options, which represents the value that would have been received by option holders had they exercised their options on December 31, 2011 at the Company’s closing stock price of $80.15. Range of exercise prices $11.63 - $20.51 $20.52 - $30.19 $30.20 - $40.22 $40.23 - $50.69 $50.70 - $78.24 Balance at December 31, 2011 (1) Number of options In millions 1.5 0.6 0.9 2.0 1.9 6.9 Options outstanding Weighted- average years to expiration Weighted- average exercise price Aggregate intrinsic value In millions Number of options In millions 1.1 1.0 5.9 5.6 7.5 4.8 $ 20.42 $ 92 $ 26.67 $ 35.18 $ 46.11 $ 58.74 29 40 69 40 $ 40.80 $ 270 1.5 0.6 0.5 1.6 0.7 4.9 Options exercisable Weighted- average exercise price Aggregate intrinsic value In millions $ 20.42 $ 92 $ 26.67 $ 35.46 $ 46.28 $ 52.50 29 24 54 18 $ 35.58 $ 217 (1) Stock options with a US dollar exercise price have been translated to Canadian dollars using the foreign exchange rate in effect at the balance sheet date. As at December 31, 2011, all stock options outstanding were in-the-money. The weighted-average years to expiration of exercisable stock options is 3.5 years. 68 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements The following table provides valuation and expense information for all stock option awards: In millions, unless otherwise indicated Year of grant 2011 2010 2009 2008 2007 2006 2005 Total Stock-based compensation expense recognized over requisite service period (1) Year ended December 31, 2011 Year ended December 31, 2010 Year ended December 31, 2009 Fair value per unit At grant date ($) $ 5 N/A N/A $ $ 2 4 N/A $ $ $ 2 2 9 $ $ $ 1 2 1 $ $ $ - 1 2 N/A - 2 $ $ N/A N/A $ - $ $ $ 10 9 14 $ 15.66 $ 13.09 $ 12.60 $ 12.44 $ 13.37 $ 13.80 $ 9.19 N/A Fair value of awards vested during the year Year ended December 31, 2011 Year ended December 31, 2010 Year ended December 31, 2009 $ - N/A N/A $ $ 2 - N/A $ $ $ Nonvested awards at December 31, 2011 Unrecognized compensation cost $ 5 $ 3 $ Remaining recognition period (years) 3.0 2.0 4 4 - 2 1.0 $ $ $ $ 3 3 3 - - $ $ $ $ 3 3 3 - - $ $ N/A 3 3 N/A N/A N/A N/A $ 3 $ $ $ 12 13 12 N/A N/A $ 10 N/A Assumptions Grant price ($) $ 68.94 $ 54.76 $ 42.14 $ 48.51 $ 52.79 $ 51.51 $ 36.33 N/A Expected stock price volatility (2) 26% 28% 39% 27% 24% 25% 25% N/A Expected term (years) (3) Risk-free interest rate (4) Dividend rate ($) (5) 5.3 5.4 5.3 5.3 5.2 5.2 5.2 N/A 2.53% 2.44% 1.97% 3.58% 4.12% 4.04% 3.50% N/A $ 1.30 $ 1.08 $ 1.01 $ 0.92 $ 0.84 $ 0.65 $ 0.50 N/A (1) Compensation cost is based on the grant date fair value using the Black-Scholes option-pricing model that uses the assumptions at the grant date. (2) Based on the average of the historical volatility of the Company’s stock over a period commensurate with the expected term of the award and the implied volatility from traded options on the Company’s stock. (3) Represents the period of time that awards are expected to be outstanding. The Company uses historical data to estimate option exercise and employee termination, and groups of employees that have similar historical exercise behavior are considered separately. (4) Based on the implied yield available on zero-coupon government issues with an equivalent term commensurate with the expected term of the awards. (5) Based on the annualized dividend rate. The following table provides information related to stock op- (iii) Stock price volatility tions exercised during the years ended December 31, 2011, 2010 Compensation cost for the Company’s RSU plans is based on the and 2009: In millions Year ended December 31, 2011 2010 2009 Total intrinsic value $ 122 $ 125 $ 93 Cash received upon exercise of options $ 68 $ 87 $ 53 Related excess tax benefit realized $ 9 $ 28 $ 20 fair value of the awards at period end using the lattice-based val- uation model for which a primary assumption is the Company’s share price. In addition, the Company’s liability for the VIDP is marked-to-market at period-end and, as such, is also reliant on the Company’s share price. Fluctuations in the Company’s share price cause volatility to stock-based compensation expense as re- corded in net income. The Company does not currently hold any derivative financial instruments to manage this exposure. A $1 in- crease in the Company’s share price at December 31, 2011 would have increased stock-based compensation expense by $3 million, whereas a $1 decrease in the price would have reduced it by $4 million. Canadian National Railway Company U.S. GAAP 2011 Annual Report 69 Notes to Consolidated Financial Statements 12 Pensions and other postretirement benefits B. Funding policy The Company has various retirement benefit plans under which substantially all of its employees are entitled to benefits at re- tirement age, generally based on compensation and length of service and/or contributions. Senior and executive management (“executive employees”) subject to certain minimum service and age requirements, are also eligible for an additional retirement benefit under their Special Retirement Stipend Agreements (“SRS”), the Supplemental Executive Retirement Plan (“SERP”) or the Defined Contribution Supplemental Executive Retirement Plan (“DC SERP”). Executive employees who breach the non- compete, non-solicitation and non-disclosure of confidential in- formation conditions of the SRS, SERP or DC SERP plans or other employment agreement will forfeit the retirement benefit under these plans. Should the Company reasonably determine that a current or former executive employee may have violated the conditions of their SRS, SERP, or DC SERP plan or other employ- ment agreement, the Company may at its discretion withhold or suspend payout of the retirement benefit pending resolution of such matter. The Company has suspended payment of the $1.5 million annual retirement benefit due to its former Chief Executive Officer (CEO) pending resolution with the former CEO of issues relating to his compliance with the non-compete, non- solicitation and non-disclosure of confidential information con- ditions contained in the former CEO’s employment agreement Employee contributions to the CN Pension Plan are determined by the plan rules. Company contributions are in accordance with the requirements of the Government of Canada legis- lation, The Pension Benefits Standards Act, 1985, including amendments thereto, and are determined by actuarial valu- ations. Due to recent legislative changes, actuarial valuations will be required on an annual basis effective for years ending on or after December 31, 2011 for all Canadian plans, or when deemed appropriate by the Office of the Superintendent of Financial Institutions (OSFI). These actuarial valuations are pre- pared in accordance with legislative requirements and with the recommendations of the Canadian Institute of Actuaries for the valuation of pension plans. The latest actuarial valuation of the CN Pension Plan for funding purposes was conducted as at December 31, 2008 and indicated a funding excess on a go- ing concern and solvency basis. The Company’s next actuarial valuation required as at December 31, 2011 will be performed in 2012. While this actuarial valuation is expected to identify a going concern surplus of approximately $1 billion, on a solvency basis a funding deficit of approximately $1.4 billion is expected due to the level of interest rates applicable during that mea- surement period and the pension plan asset returns. The fed- eral pension legislation requires funding deficits, as calculated under current pension regulations, to be paid over a number of years. Actuarial valuations are also required annually for the and in respect of which the Company has commenced legal Company’s U.S. pension plans. proceedings. The Company also offers postretirement benefits to certain employees providing life insurance, medical benefits and, for a closed group of employees, free rail travel benefits during retire- ment. These postretirement benefits are funded as they become due. The information in the tables that follow pertains to all of the Company’s defined benefit plans. However, the following descriptions relate solely to the Company’s main pension plan, the CN Pension Plan, unless otherwise specified. A. Description of the CN Pension Plan The CN Pension Plan is a contributory defined benefit pension plan that covers the majority of CN employees. It provides for pensions based mainly on years of service and final average pen- In 2011, in anticipation of its future funding requirements, the Company made voluntary contributions of $350 million in excess of the required contributions mainly to strengthen the fi- nancial position of its main pension plan, the CN Pension Plan. The Company has been advised by the OSFI that this contri- bution can be treated as a prepayment against its 2012 pen- sion deficit funding requirements. As a result, the Company’s cash contributions for 2012 are expected to be in the range of approximately $275 million to $575 million for all its pen- sion plans and include a voluntary contribution of approximate- ly $150 million to $450 million. As at February 3, 2012, the Company contributed $250 million to its defined benefit pen- sion plans including a $150 million voluntary contribution. sionable earnings and is generally applicable from the first day C. Plan assets of employment. Indexation of pensions is provided after retire- ment through a gain/loss sharing mechanism, subject to guar- anteed minimum increases. An independent trust company is the Trustee of the Company’s pension trust funds (including the CN Pension Trust Fund). As Trustee, the trust company performs certain duties, which include holding legal title to the assets of the CN Pension Trust Fund and ensuring that the Company, as Administrator, complies with the provisions of the CN Pension Plan and the related legislation. The Company utilizes a measure- ment date of December 31 for the CN Pension Plan. The assets of the Company’s various plans are held in separate trust funds which are diversified by asset type, country and in- vestment strategies. Each year, the CN Board of Directors re- views and confirms or amends the Statement of Investment Policies and Procedures (SIPP) which includes the plans’ long- term asset class mix and related benchmark indices (Policy). This Policy is based on a long-term forward-looking view of the world economy, the dynamics of the plans’ benefit liabilities, the market return expectations of each asset class and the current state of financial markets. The Policy mix in 2011 was: 2% cash 70 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements and short-term investments, 38% bonds, 47% equities, 4% real The plans’ investment manager monitors market events and estate, 5% oil and gas and 4% infrastructure assets. exposures to markets, currencies and interest rates daily. When Annually, the CN Investment Division, a division of the investing in foreign securities, the plans are exposed to foreign Company created to invest and administer the assets of the currency risk that may be adjusted or hedged; the effect of plans, proposes a short-term asset mix target (Strategy) for the which is included in the valuation of the foreign securities. Net coming year, which is expected to differ from the Policy, because of the effects mentioned above, the plans were 71% exposed to of current economic and market conditions and expectations. the Canadian dollar, 7% to European currencies, 11% to the US The Investment Committee of the Board (Committee) regularly dollar and 11% to various other currencies as at December 31, compares the actual asset mix to the Policy and Strategy asset 2011. Interest rate risk represents the risk that the fair value of mixes and evaluates the actual performance of the trust funds the investments will fluctuate due to changes in market inter- in relation to the performance of the Policy, calculated using est rates. Sensitivity to interest rates is a function of the tim- Policy asset mix and the performance of the benchmark indices. ing and amount of cash flows of the assets and liabilities of the The Committee’s approval is required for all major invest- plans. To manage credit risk, established policies require deal- ments in illiquid securities. The SIPP allows for the use of deriva- ing with counterparties considered to be of high credit quality. tive financial instruments to implement strategies or to hedge Derivatives are used from time to time to adjust asset mix or ex- or adjust existing or anticipated exposures. The SIPP prohib- posures to foreign currencies, interest rate or market risks of the its investments in securities of the Company or its subsidiar- portfolio or anticipated transactions. Derivatives are contractual ies. Investments held in the trust funds consist mainly of the agreements whose value is derived from interest rates, foreign following: exchange rates, equity or commodity prices. When derivatives (i) Cash, short-term investments and bonds consist primarily are used for hedging purposes, the gains or losses on the deriv- of highly liquid securities which ensure adequate cash flows atives are offset by a corresponding change in the value of the are available to cover near-term benefit payments. Short- hedged assets. Derivatives may include forwards, futures, swaps term securities are almost exclusively obligations issued by and options. Canadian chartered banks. As at December 31, 2011, 93% The tables on the following page present the fair value of of bonds were issued or guaranteed by Canadian, U.S. or plan assets excluding the economic exposure of derivatives as at other governments. December 31, 2011 and 2010 by asset class, their level within (ii) Mortgages consist of mortgage products which are primari- the fair value hierarchy and the valuation techniques and inputs ly conventional or participating loans secured by commercial used to measure such fair value. properties and publicly traded REITs (Real Estate Investment Trust). (iii) Equity investments are well diversified by country, issuer and industry sector. The most significant allocation either to an individual issuer or industry sector was approximately 4% and 21%, respectively, in 2011. (iv) Real estate is a diversified portfolio of Canadian land and commercial properties. (v) Oil and gas investments include petroleum and natural gas properties operated by the trusts’ wholly-owned subsidiar- ies and Canadian marketable securities. (vi) Infrastructure investments are publically traded trust units, participations in private infrastructure funds and public debt and equity securities of infrastructure and utility companies. (vii) Absolute return investments are a portfolio of units of ex- ternally managed hedge funds. Canadian National Railway Company U.S. GAAP 2011 Annual Report 71 Notes to Consolidated Financial Statements 12 Pensions and other postretirement benefits continued In millions, unless otherwise indicated Fair value measurements at December 31, 2011 Asset class Total Percentage of total assets Level 1 Level 2 Level 3 Cash and short-term investments (1) $ 1,026 7.0% $ 21 $ 1,005 $ Bonds (2) Canada and supranational Provinces of Canada Emerging market debt Mortgages (3) Equities (4) Canadian U.S. International Real estate (5) Oil and gas (6) Infrastructure (7) Absolute return (8) Multi-strategy funds Fixed income funds Equity funds Global macro funds Other (9) Total plan assets Bonds (2) Canada and supranational Provinces of Canada Corporate Emerging market debt Mortgages (3) Equities (4) Canadian U.S. International Real estate (5) Oil and gas (6) Infrastructure (7) Absolute return (8) Multi-strategy funds Fixed income funds Commodity funds Equity funds Global macro funds Other (9) Total plan assets 1,650 1,937 288 178 2,395 1,125 2,712 214 1,232 707 358 214 260 368 11.2% 13.1% 2.0% 1.2% 16.3% 7.6% 18.4% 1.5% 8.4% 4.8% 2.4% 1.5% 1.8% 2.5% - - - 8 2,373 1,087 2,680 - 343 9 - - - - 1,650 1,937 288 170 - 38 32 - - 79 358 214 260 368 $ 14,664 99.7% $ 6,521 $ 6,399 $ 1,744 55 $ 14,719 0.3% 100% 2,013 1,292 92 318 205 3,228 1,316 3,076 318 1,141 607 311 197 75 148 292 13.3% 8.6% 0.6% 2.1% 1.4% 21.4% 8.7% 20.4% 2.1% 7.6% 4.0% 2.1% 1.3% 0.5% 1.0% 1.9% - - - - 30 3,204 1,316 3,076 - 289 29 - - - - - 2,013 1,292 92 318 175 - - - - - 85 106 197 75 147 292 - - - - - 22 - - 214 889 619 - - - - - - - - - - 24 - - 318 852 493 205 - - 1 - In millions, unless otherwise indicated Fair value measurements at December 31, 2010 Asset class Total Percentage of total assets Level 1 Level 2 Level 3 Cash and short-term investments (1) $ 429 2.8% $ 429 $ - $ $ 15,058 99.8% $ 8,373 $ 4,792 $ 1,893 34 $ 15,092 0.2% 100% Level 1: Fair value based on quoted prices in active markets for identical assets Level 2: Fair value based on significant observable inputs Level 3: Fair value based on significant unobservable inputs 72 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements The following table reconciles the beginning and ending balances of the fair value of investments classified as Level 3. Fair value measurements using significant unobservable inputs (Level 3) In millions Equities (4) Real estate (5) Oil and Infra- Absolute gas (6) structure (7) return (8) Total Additional information (10) Infra- structure hedged Absolute return hedged Beginning balance at December 31, 2009 $ 18 $ 266 $ 752 $ 449 $ 182 $ 1,667 $ 449 $ 182 Actual return relating to assets still held at the reporting date Purchases, sales and settlements Transfers in and/or out of Level 3 3 3 - 32 (14) 34 90 (48) 58 19 25 - (11) 109 (74) 133 75 18 46 1 - - 99 (74) Balance at December 31, 2010 $ 24 $ 318 $ 852 $ 493 $ 206 $ 1,893 $ 496 $ 207 Actual return relating to assets still held at the reporting date Purchases, sales and settlements Transfers in and/or out of Level 3 2 (4) - 58 (162) - 90 (53) - 74 52 - (7) (1) (198) 217 (168) (198) 63 62 - (8) (1) (198) Ending balance at December 31, 2011 $ 22 $ 214 $ 889 $ 619 $ - $ 1,744 $ 621 $ - (1) Short-term investments consist primarily of securities issued by Canadian chartered banks. Such investments are valued at cost, which approximates fair value. (2) Bonds are valued using prices obtained from independent pricing data suppliers, predominantly TSX Inc. When prices are not available from independent sources, the bond is valued by comparison to prices obtained for a bond of similar interest rate, maturity and risk. (3) Mortgages are secured by real estate. The fair value measurement of $170 million ($175 million in 2010) of mortgages categorized as Level 2 is based on current market yields of financial instruments of similar maturity, coupon and risk factors. Mortgages denominated in foreign currencies are fully hedged back to the Canadian dollar, the effects of which are reflected in the values presented in the tables above. (4) The fair value of equity investments of $22 million ($24 million in 2010) categorized as Level 3 represent units in private equity funds which are valued by their administrators. (5) The fair value of real estate investments of $214 million ($318 million in 2010) includes land and buildings classified as Level 3. Land is valued based on the fair value of comparable assets, and buildings are valued based on the present value of estimated future net cash flows or the fair value of comparable assets. Independent valuations of land and buildings are performed triennially. (6) The fair value of oil and gas investments of $889 million ($852 million in 2010) classified as Level 3 is valued based on estimated future net cash flows that are discounted using prevailing market rates for transactions in similar assets. The future net cash flows are based on forecasted oil and gas prices and projected future annual production and costs. (7) Infrastructure funds consist of $9 million ($29 million in 2010) of trust units that are publicly traded and classified as Level 1, $79 million ($85 million in 2010) of bank loans and bonds issued by infrastructure companies classified as Level 2 and $619 million ($493 million in 2010) of infrastructure funds that are classified as Level 3 and are valued based on earnings multiples. Infrastructure funds cannot be redeemed; distributions will be received from the funds as the underlying investments are liquidated. Infrastructure funds denominated in foreign currencies are fully hedged back to the Canadian dollar, the effects of which are reflected in the values presented in the additional information table presented above. (8) Absolute return investments are valued using the net asset value as reported by the fund administrators. All hedge fund investments have contractual redemption frequencies, ranging from monthly to annually, and redemption notice periods varying from 5 to 90 days. Hedge fund investments that have redemption dates less frequent than every four months or that have restrictions on contractual redemption features at the reporting date are classified as Level 3. During the year, absolute return investments having a fair value of $198 million (nil in 2010) were transferred from Level 3 to Level 2 as the restrictions on redemption were lifted. (9) Other consists of net operating assets required to administer the trust funds’ investment assets and the plans’ benefit and funding activities. Such assets are valued at cost and have not been assigned to a fair value category. (10) This additional information demonstrates the fair value of the infrastructure and absolute return funds after considering the effects of foreign currency hedges. Canadian National Railway Company U.S. GAAP 2011 Annual Report 73 Notes to Consolidated Financial Statements 12 Pensions and other postretirement benefits continued D. Additional disclosures (i) Obligations and funded status In millions Year ended December 31, 2011 2010 2011 2010 Pensions Other postretirement benefits Change in benefit obligation Projected benefit obligation at beginning of year $ 14,895 $ 13,708 $ 283 $ 268 Amendments Interest cost Actuarial loss (gain) Service cost Curtailment gain Plan participants’ contributions Foreign currency changes Benefit payments, settlements and transfers 27 788 577 124 - 54 5 (922) 5 837 1,118 99 - 50 (12) (910) 1 14 (2) 4 (1) - 3 (18) - 16 22 3 (1) - (6) (19) Projected benefit obligation at end of year $ 15,548 $ 14,895 $ 284 $ 283 Component representing future salary increases (437) (439) - - Accumulated benefit obligation at end of year $ 15,111 $ 14,456 $ 284 $ 283 Change in plan assets Fair value of plan assets at beginning of year $ 15,092 $ 14,332 Employer contributions Plan participants’ contributions Foreign currency changes Actual return on plan assets Benefit payments, settlements and transfers 458 54 1 36 (922) 411 50 (8) 1,217 (910) Fair value of plan assets at end of year $ 14,719 $ 15,092 $ $ - - - - - - - $ $ - - - - - - - Funded status (Excess (deficiency) of fair value of plan assets over projected benefit obligation at end of year) Measurement date for all plans is December 31. $ (829) $ 197 $ (284) $ (283) The projected benefit obligation and fair value of plan assets for the CN Pension Plan at December 31, 2011 were $14,514 million and $13,992 million respectively ($13,941 million and $14,343 million, respectively, at December 31, 2010). (ii) Amounts recognized in the Consolidated Balance Sheet In millions Noncurrent assets (Note 6) Current liabilities (Note 7) Noncurrent liabilities Total amount recognized December 31, 2011 2010 2011 2010 Pensions Other postretirement benefits $ - - (829) $ 442 $ - $ - - (245) (18) (266) (18) (265) $ (829) $ 197 $ (284) $ (283) (iii) Amounts recognized in Accumulated other comprehensive loss (Note 19) In millions Net actuarial gain (loss) Prior service cost Pensions Other postretirement benefits December 31, 2011 $ (2,720) $ (30) 2010 (1,185) (5) $ $ 2011 2010 $ $ 3 (3) $ $ 1 (4) 74 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements (iv) Information for the pension plans with an accumulated benefit obligation in excess of plan assets In millions December 31, 2011 2010 Projected benefit obligation Accumulated benefit obligation Fair value of plan assets $ 15,015 $ 14,606 $ 14,191 $ $ $ 436 386 191 2011 N/A N/A N/A 2010 N/A N/A N/A Pensions Other postretirement benefits (v) Components of net periodic benefit cost (income) Year ended December 31, 2011 Pensions 2010 2009 2011 2010 2009 Other postretirement benefits In millions Service cost Interest cost Curtailment gain Settlement loss Expected return on plan assets Amortization of prior service cost Recognized net actuarial loss (gain) $ 124 $ 99 $ 83 $ 788 - 3 837 885 - - - - (1,005) (1,009) (1,007) 2 8 - 3 - 5 4 14 (1) - - 2 - $ 3 16 (1) - - 2 (2) $ 3 17 (3) - - 5 (3) Net periodic benefit cost (income) $ (80) $ (70) $ (34) $ 19 $ 18 $ 19 The estimated prior service cost and net actuarial loss for defined benefit pension plans that will be amortized from Accumulated other comprehensive loss into net periodic benefit cost (income) over the next fiscal year are $4 million and $123 million, respectively. The estimated prior service cost and net actuarial gain for other postretirement benefits that will be amortized from Accumulated other comprehensive loss into net periodic benefit cost (income) over the next fiscal year are $2 million and nil, respectively. (vi) Weighted-average assumptions used in accounting for pensions and other postretirement benefits December 31, 2011 Pensions 2010 2009 2011 2010 2009 Other postretirement benefits To determine projected benefit obligation Discount rate (1) Rate of compensation increase (2) To determine net periodic benefit cost Discount rate (1) Rate of compensation increase (2) Expected return on plan assets (3) 4.84% 5.32% 3.25% 3.50% 5.32% 6.19% 3.50% 3.50% 7.50% 7.75% 6.19% 3.50% 7.42% 3.50% 7.75% 4.70% 5.29% 6.01% 3.25% 3.50% 3.50% 5.29% 6.01% 6.84% 3.50% 3.50% 3.50% N/A N/A N/A (1) The Company’s discount rate assumption, which is set annually at the end of each year, is used to determine the projected benefit obligation at the end of the year and the net periodic benefit cost for the following year. The discount rate is used to measure the single amount that, if invested at the measurement date in a portfolio of high-quality debt instruments with a rating of AA or better, would provide the necessary cash flows to pay for pension benefits as they become due. The discount rate is determined by management with the aid of third- party actuaries. The Company’s methodology for determining the discount rate is based on a zero-coupon bond yield curve, which is derived from semi-annual bond yields provided by a third party. The portfolio of hypothetical zero-coupon bonds is expected to generate cash flows that match the estimated future benefit payments of the plans as the bond rate for each maturity year is applied to the plans’ corresponding expected benefit payments of that year. (2) The rate of compensation increase is determined by the Company based upon its long-term plans for such increases. (3) To develop its expected long-term rate of return assumption used in the calculation of net periodic benefit cost applicable to the market-related value of assets, the Company considers multiple factors. The expected long-term rate of return is determined based on expected future performance for each asset class and is weighted based on the current asset portfolio mix. Consideration is taken of the historical performance, the premium return generated from an actively managed portfolio, as well as current and future anticipated asset allocations, economic developments, inflation rates and administrative expenses. Based on these factors, the rate is determined by the Company. For 2011, the Company used a long-term rate of return assumption of 7.50% on the market-related value of plan assets to compute net periodic benefit cost. The Company has elected to use a market-related value of assets, whereby realized and unrealized gains/losses and appreciation/depreciation in the value of the investments are recognized over a period of five years, while investment income is recognized immediately. Effective January 1, 2012 the Company will reduce the expected long-term rate of return on plan assets from 7.50% to 7.25% to reflect management’s current view of long term investment returns. The effect of this change in management’s assumption will be to increase net periodic benefit cost by approximately $20 million. Canadian National Railway Company U.S. GAAP 2011 Annual Report 75 Notes to Consolidated Financial Statements 12 Pensions and other postretirement benefits continued (vii) Health care cost trend rate for other postretirement benefits For measurement purposes, increases in the per capita cost of covered health care benefits were assumed to be 10% and 9% for 2011 and 2012, respectively. It is assumed that the rate will decrease gradually to 4.5% in 2028 and remain at that level thereafter. Assumed health care costs have a significant effect on the amounts reported for the health care plan. A one-percentage-point change in the assumed health care cost trend rate would have the following effect: In millions Effect on total service and interest costs Effect on benefit obligation (viii) Estimated future benefit payments In millions 2012 2013 2014 2015 2016 Years 2017 to 2021 One-percentage-point Increase Decrease $ 1 $ 16 $ (1) $ (14) Other postretirement benefits $ 18 $ 18 $ 19 $ 19 $ 19 $ 98 Pensions $ $ 973 996 $ 1,018 $ 1,040 $ 1,060 $ 5,444 E. Defined contribution and other plans 13 Other income In millions Year ended December 31, 2011 2010 2009 Gain on disposals of properties (1) $ 348 $ 157 $ 226 Gain on disposal of land Investment income Other 30 3 20 20 5 30 12 7 22 Total other income $ 401 $ 212 $ 267 (1) 2011 includes $60 million and $288 million for the disposal of substantially all of the assets of ICRMT and of a segment of the Company’s Kingston subdivision known as the Lakeshore East, respectively, 2010 includes $152 million for the sale of a portion of the property known as the Oakville subdivision and 2009 includes $69 million and $157 million for the sales of the Lower Newmarket and Weston subdivisions, respectively. See Note 5 - Properties. The Company maintains defined contribution pension plans for certain salaried employees as well as certain employees covered by collective bargaining agreements. The Company also maintains other plans including Section 401(k) savings plans for certain U.S. based employees. The Company’s contributions under these plans are expensed as incurred and amounted to $10 million, $16 mil- lion and $8 million for 2011, 2010 and 2009, respectively. F. Contributions to multi-employer plan Under collective bargaining agreements, the Company par- ticipates in a multiemployer benefit plan named the Railroad Employees National Early Retirement Major Medical Benefit Plan which is administered by the National Carriers’ Conference Committee (NCCC), and provides certain postretirement health care benefits to certain retirees. The Company’s contributions un- der this plan are expensed as incurred and amounted to $11 mil- lion, $10 million and $8 million in 2011, 2010 and 2009, respec- tively. The annual contribution rate for the plan is determined by the NCCC and for 2011 was $164.41 per month per active employee ($155.96 in 2010). The plan covered 846 retirees in 2011 (716 in 2010). 76 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements 14 Income taxes As at December 31, 2011, Deferred and receivable income taxes include a net deferred income tax asset of $46 million ($53 mil- lion as at December 31, 2010) and an income tax receivable of $76 million (nil as at December 31, 2010). The Company’s consolidated effective income tax rate differs from the Canadian, or domestic, statutory Federal tax rate. The effective tax rate is affected by recurring items such as tax rates in provincial, U.S. federal, state and other foreign jurisdictions and the proportion of income earned in those jurisdictions. The effec- tive tax rate is also affected by discrete items such as income tax rate enactments and lower tax rates on capital dispositions that may occur in any given year. The reconciliation of income tax ex- pense is as follows: Significant components of deferred income tax assets and liabilities are as follows: In millions December 31, 2011 2010 Deferred income tax assets Pension liability $ 226 $ - Personal injury claims and other reserves Other postretirement benefits liability Net operating losses and tax credit carryforwards (1) Total deferred income tax assets Deferred income tax liabilities Properties Net pension asset Other Total deferred income tax liabilities Total net deferred income tax liability 134 85 5 450 155 88 11 254 5,618 5,129 - 119 41 183 5,737 5,353 $ 5,287 $ 5,099 $ 2,046 $ 2,162 3,241 2,937 $ 5,287 $ 5,099 In millions Year ended December 31, 2011 2010 2009 Total net deferred income tax liability Federal tax rate 16.5% 18.0% 19.0% Income tax expense at the statutory Federal tax rate $ (554) $ (518) $ (430) Domestic Foreign Income tax (expense) recovery resulting from: Provincial and foreign taxes (360) (308) (213) Deferred income tax adjustments due to rate enactments Gain on disposals Other (1) (40) 62 (7) - 32 22 126 42 68 Total net deferred income tax liability $ 5,287 $ 5,099 Net current deferred income tax asset 46 53 Net noncurrent deferred income tax liability $ 5,333 $ 5,152 (1) Net operating losses and tax credit carryforwards will expire between the years 2014 and 2031. Income tax expense $ (899) $ (772) $ (407) On an annual basis, the Company assesses the need to es- Cash payments for income taxes $ 482 $ 214 $ 245 tablish a valuation allowance for its deferred income tax assets, (1) Comprises adjustments relating to the resolution of matters pertaining to prior years’ and if it is deemed more likely than not that its deferred income income taxes, including net recognized tax benefits, and other items. The following table provides tax information on a domestic and foreign basis: tax assets will not be realized, a valuation allowance is recorded. The ultimate realization of deferred income tax assets is depen- dant upon the generation of future taxable income during the periods in which those temporary differences become deductible. In millions Year ended December 31, 2011 2010 2009 Management considers the scheduled reversals of deferred income Income before income taxes Domestic Foreign Current income tax expense Domestic Foreign Deferred income tax expense Domestic Foreign tax liabilities including the available carryback and carryforward $ 2,464 $ 2,052 $ 1,738 periods, projected future taxable income, and tax planning strate- 892 824 523 gies in making this assessment. As at December 31, 2011, in order $ 3,356 $ 2,876 $ 2,261 to fully realize all of the deferred income tax assets, the Company $ (340) $ (306) $ (244) (28) (48) (25) $ (368) $ (354) $ (269) $ (288) $ (248) $ (58) (243) (170) (80) $ (531) $ (418) $ (138) will need to generate future taxable income of approximately $1.6 billion and, based upon the level of historical taxable income and projections of future taxable income over the periods in which the deferred income tax assets are deductible, management believes it is more likely than not that the Company will realize the benefits of these deductible differences. Management has assessed the im- pacts of the current economic environment and concluded there are no significant impacts to its assertions for the realization of deferred income tax assets. The Company has not recognized a deferred income tax asset ($280 million as at December 31, 2011) on the unrealized foreign exchange loss recorded in Accumulated other comprehensive loss relating to its permanent investment in foreign subsidiaries, as the Company does not expect this tempo- rary difference to reverse in the foreseeable future. Canadian National Railway Company U.S. GAAP 2011 Annual Report 77 Notes to Consolidated Financial Statements 14 Income taxes continued which are expected to be completed during 2012. Current on- going examinations on specific tax positions taken for federal The Company recognized tax credits of $1 million in each of and provincial income tax returns filed for the 2006 year are 2011 and 2010, and $6 million in 2009 for eligible research and also expected to be completed during 2012. In the U.S., both development expenditures, which reduced the cost of properties. the federal and state income tax returns filed for the years The following table provides a reconciliation of unrecog- 2007 to 2010 remain subject to examination by the taxation nized tax benefits on the Company’s domestic and foreign tax authorities. In the fourth quarter of 2011, the taxation authori- positions: In millions Year ended December 31, 2011 2010 2009 Gross unrecognized tax benefits at beginning of year $ 57 $ 83 $ 79 Increases for: Tax positions related to the current year Tax positions related to prior years Decreases for: Tax positions related to prior years Settlements 1 11 - (21) Lapse of the applicable statute of limitations (2) 4 5 (31) - (4) 11 4 (2) (2) (7) ties commenced examinations of the Company’s Indiana state income tax returns for 2008 to 2010 which are expected to be completed during 2012. Current on-going examinations of the Company’s Wisconsin state income tax returns for 2003 to 2006 are also expected to be completed during 2012. The Company does not anticipate any significant impacts to its results of op- erations or financial position as a result of the final resolutions of such matters. 15 Segmented information $ 46 $ 57 $ 83 The Company manages its operations as one business segment Gross unrecognized tax benefits at end of year Adjustments to reflect tax treaties and other arrangements (11) (27) (46) Net unrecognized tax benefits at end of year $ 35 $ 30 $ 37 As at December 31, 2011, the total amount of gross un- recognized tax benefits was $46 million, before considering tax treaties and other arrangements between taxation authori- ties. If recognized, all of the net unrecognized tax benefits as at December 31, 2011 would affect the effective tax rate. The Company believes that it is reasonably possible that approxi- mately $16 million of the net unrecognized tax benefits as at December 31, 2011 related to various federal, state, and pro- vincial income tax matters, each of which are individually in- significant, may be recognized over the next twelve months as a result of settlements and a lapse of the applicable statute of limitations. The Company recognizes accrued interest and penalties re- lated to unrecognized tax benefits in Income tax expense in the Company’s Consolidated Statement of Income. The Company recognized approximately $4 million, $5 million and $4 mil- lion in accrued interest and penalties during the years ended December 31, 2011, 2010 and 2009, respectively. The Company had approximately $13 million and $19 million of accrued interest and penalties as at December 31, 2011 and 2010, respectively. In Canada, the Company’s federal income tax returns filed for the years 2007 to 2010 and the provincial income tax re- turns filed for the years 2006 to 2010 remain subject to ex- amination by the taxation authorities. In the second quarter of 2011, the taxation authorities commenced examinations of the Company’s federal income tax returns for 2007 and 2008 over a single network that spans vast geographic distances and territories, with operations in Canada and the United States. Financial information reported at this level, such as revenues, op- erating income, and cash flow from operations, is used by corpo- rate management, including the Company’s chief operating deci- sion-maker, in evaluating financial and operational performance and allocating resources across CN’s network. The Company’s strategic initiatives, which drive its operation- al direction, are developed and managed centrally by corporate management and are communicated to its regional activity cen- ters (the Western Region, Eastern Region and Southern Region). Corporate management is responsible for, among others, CN’s marketing strategy, the management of large customer ac- counts, overall planning and control of infrastructure and rolling stock, the allocation of resources, and other functions such as financial planning, accounting and treasury. The role of each region is to manage the day-to-day service requirements within their respective territories and control direct costs incurred locally. Such cost control is required to ensure that pre-established efficiency standards set at the corporate level are met. The regions execute the overall corporate strategy and operating plan established by corporate management, as their management of throughput and control of direct costs does not serve as the platform for the Company’s decision-making process. Approximately 90% of the Company’s freight revenues are from national accounts for which freight traffic spans North America and touches various commodity groups. As a result, the Company does not manage revenues on a regional basis since a large number of the movements originate in one region and pass through and/or terminate in another region. 78 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements The regions also demonstrate common characteristics in each 16 Earnings per share of the following areas: (i) each region’s sole business activity is the transportation of Year ended December 31, 2011 2010 2009 freight over the Company’s extensive rail network; Basic earnings per share $ 5.45 $ 4.51 $ 3.95 (ii) the regions service national accounts that extend over the Diluted earnings per share $ 5.41 $ 4.48 $ 3.92 Company’s various commodity groups and across its rail network; (iii) the services offered by the Company stem predominantly The following table provides a reconciliation between basic and diluted earnings per share: from the transportation of freight by rail with the goal of op- In millions Year ended December 31, 2011 2010 2009 timizing the rail network as a whole; (iv) the Company and its subsidiaries, not its regions, are subject to single regulatory regimes in both Canada and the U.S. For the reasons mentioned herein, the Company reports as one operating segment. The following tables provide information by geographic area: In millions Year ended December 31, 2011 2010 2009 Revenues (1) Canada U.S. $ 6,169 $ 5,630 $ 4,971 2,859 2,667 2,396 $ 9,028 $ 8,297 $ 7,367 (1) For the years ended December 31, 2011, 2010 and 2009, the largest customer represented approximately 3% of total revenues for each year. Net income $ 2,457 $ 2,104 $ 1,854 Weighted-average shares outstanding 451.1 466.3 469.2 Effect of stock options 3.3 3.8 4.3 Weighted-average diluted shares outstanding 454.4 470.1 473.5 Basic earnings per share are calculated based on the weight- ed-average number of common shares outstanding over each period. Diluted earnings per share are calculated based on the weighted-average diluted shares outstanding using the treasury stock method, which assumes that any proceeds received from the exercise of in-the-money stock options would be used to purchase common shares at the average market price for the pe- riod. For the years ended December 31, 2011, 2010 and 2009, the weighted-average number of stock options that were not in- In millions Year ended December 31, 2011 2010 2009 cluded in the calculation of diluted earnings per share, as their inclusion would have had an anti-dilutive impact, were 0.1 mil- lion, nil and 0.4 million, respectively. Net income Canada U.S. In millions Properties Canada U.S. $ 1,836 $ 1,498 $ 1,436 621 606 418 $ 2,457 $ 2,104 $ 1,854 December 31, 2011 2010 $ 13,824 $ 13,312 10,093 9,605 $ 23,917 $ 22,917 Canadian National Railway Company U.S. GAAP 2011 Annual Report 79 Notes to Consolidated Financial Statements 17 Major commitments and contingencies A. Leases The Company has operating and capital leases, mainly for loco- motives, freight cars and intermodal equipment. Of the capital leases, many provide the option to purchase the leased items at fixed values during or at the end of the lease term. As at to adjustment. In addition, remaining implementation costs as- sociated with the U.S. federal government legislative require- ment to implement positive train control (PTC) by 2015 are es- timated to be approximately $193 million (US$190 million). The Company also has agreements with fuel suppliers to purchase approximately 61% of its estimated 2012 volume, 41% of its an- ticipated 2013 volume and 11% of its anticipated 2014 volume December 31, 2011, the Company’s commitments under these at market prices prevailing on the date of the purchase. operating and capital leases were $665 million and $1,254 mil- lion, respectively. Minimum rental payments for operating leases C. Contingencies having initial non-cancelable lease terms of more than one year and minimum lease payments for capital leases in each of the next five years and thereafter are as follows: In millions 2012 2013 2014 2015 2016 2017 and thereafter Operating Capital $ 128 $ 99 103 151 76 61 45 270 109 297 252 328 $ 665 1,254 Less: imputed interest on capital leases at rates ranging from approximately 0.7% to 11.8% Present value of minimum lease payments included in debt 299 $ 955 In the normal course of business, the Company becomes in- volved in various legal actions seeking compensatory and occa- sionally punitive damages, including actions brought on behalf of various purported classes of claimants and claims relating to employee and third-party personal injuries, occupational disease and property damage, arising out of harm to individuals or prop- erty allegedly caused by, but not limited to, derailments or other accidents. Canada Employee injuries are governed by the workers’ compensation legislation in each province whereby employees may be awarded either a lump sum or future stream of payments depending on the nature and severity of the injury. As such, the provision for employee injury claims is discounted. In the provinces where the Company is self-insured, costs related to employee work-related The Company also has operating lease agreements for its injuries are accounted for based on actuarially developed esti- automotive fleet with one-year non-cancelable terms for which mates of the ultimate cost associated with such injuries, includ- its practice is to renew monthly thereafter. The estimated annual ing compensation, health care and third-party administration rental payments for such leases are approximately $30 million costs. A comprehensive actuarial study is generally performed at and generally extend over five years. least on a triennial basis. For all other legal actions, the Company Rent expense for all operating leases was $143 million, maintains, and regularly updates on a case-by-case basis, pro- $176 million and $213 million for the years ended December 31, visions for such items when the expected loss is both probable 2011, 2010 and 2009, respectively. Contingent rentals and sub- and can be reasonably estimated based on currently available lease rentals were not significant. information. B. Commitments As at December 31, 2011, the Company had commitments to acquire railroad ties, rail, freight cars, locomotives, and other equipment and services, as well as outstanding information technology service contracts and licenses, at an aggregate cost of $727 million ($740 million as at December 31, 2010). The Company also has remaining estimated commitments in relation to the acquisition of the principal lines of the former Elgin, Joliet and Eastern Railway Company of approximately $130 million to be spent over the next few years for railroad infrastructure im- provements, grade separation projects, as well as commitments under a series of agreements with individual communities and a comprehensive voluntary mitigation program established to ad- dress surrounding municipalities’ concerns. The commitment for the grade separation projects is based on estimated costs pro- vided by the STB at the time of acquisition and could be subject As at December 31, 2011, 2010 and 2009, the Company’s provision for personal injury and other claims in Canada was as follows: In millions 2011 2010 2009 Balance January 1 $ 200 $ 178 $ 189 Accruals and other Payments 31 (32) 59 (37) 48 (59) Balance December 31 $ 199 $ 200 $ 178 Current portion - Balance December 31 $ 39 $ 39 $ 34 United States Personal injury claims by the Company’s employees, including claims alleging occupational disease and work-related injuries, are subject to the provisions of the Federal Employers’ Liability Act (FELA). Employees are compensated under FELA for damages 80 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements assessed based on a finding of fault through the U.S. jury system Although the Company considers such provisions to be ad- or through individual settlements. As such, the provision is un- equate for all its outstanding and pending claims, the final discounted. With limited exceptions where claims are evaluated outcome with respect to actions outstanding or pending at on a case-by-case basis, the Company follows an actuarial-based December 31, 2011, or with respect to future claims, cannot be approach and accrues the expected cost for personal injury, in- reasonably determined. When establishing provisions for contin- cluding asserted and unasserted occupational disease claims, gent litigation, the Company considers, where a probable loss and property damage claims, based on actuarial estimates of estimate cannot be made with reasonable certainty, a range of their ultimate cost. A comprehensive actuarial study is performed potential probable losses for each such matter, and records the annually. amount it considers the most reasonable estimate within the For employee work-related injuries, including asserted occu- range. However, when no amount within the range is a better pational disease claims, and third-party claims, including grade estimate than any other amount, the minimum amount in the crossing, trespasser and property damage claims, the actuarial range is accrued. For matters where a loss is reasonably possible valuation considers, among other factors, CN’s historical patterns but not probable, a range of potential losses could not be esti- of claims filings and payments. For unasserted occupational dis- mated due to various factors which may include the limited avail- ease claims, the actuarial study includes the projection of CN’s ability of facts, the lack of demand for specific damages and the experience into the future considering the potentially exposed fact that proceedings were at an early stage. Based on informa- population. The Company adjusts its liability based upon man- tion currently available, the Company believes that the eventual agement’s assessment and the results of the study. On an ongo- outcome of the actions against the Company will not, individu- ing basis, management reviews and compares the assumptions ally or in the aggregate, have a material adverse effect on the inherent in the latest actuarial study with the current claim expe- Company’s consolidated financial position. However, due to the rience and, if required, adjustments to the liability are recorded. inherent inability to predict with certainty unforeseeable future Due to the inherent uncertainty involved in projecting future developments, there can be no assurance that the ultimate reso- events, including events related to occupational diseases, which lution of these actions will not have a material adverse effect on include but are not limited to, the timing and number of actual the Company’s results of operations, financial position or liquid- claims, the average cost per claim and the legislative and judicial ity in a particular quarter or fiscal year. environment, the Company’s future payments may differ from current amounts recorded. D. Environmental matters External actuarial studies reflecting favorable claims devel- The Company’s operations are subject to numerous federal, pro- opment over recent years have supported net reductions to the vincial, state, municipal and local environmental laws and regula- Company’s provision for U.S. personal injury and other claims of tions in Canada and the United States concerning, among other $6 million, $19 million and $60 million in 2011, 2010 and 2009, things, emissions into the air; discharges into waters; the genera- respectively. The reductions were mainly attributable to decreas- tion, handling, storage, transportation, treatment and disposal es in the Company’s estimates of unasserted claims and costs of waste, hazardous substances, and other materials; decommis- related to asserted claims as a result of its ongoing risk mitiga- sioning of underground and aboveground storage tanks; and soil tion strategy focused on reducing the frequency and severity of and groundwater contamination. A risk of environmental liability claims through injury prevention and containment; mitigation of is inherent in railroad and related transportation operations; real claims; and lower settlements for existing claims. estate ownership, operation or control; and other commercial As at December 31, 2011, 2010 and 2009, the Company’s activities of the Company with respect to both current and past provision for personal injury and other claims in the U.S. was as operations. follows: In millions 2011 2010 2009 Known existing environmental concerns Balance January 1 $ 146 $ 166 $ 265 Accruals and other Payments 30 (65) 7 (27) (46) (53) Balance December 31 $ 111 $ 146 $ 166 Current portion - Balance December 31 $ 45 $ 44 $ 72 The Company has identified approximately 310 sites at which it is or may be liable for remediation costs, in some cases along with other potentially responsible parties, associated with alleged contamination and is subject to environmental clean-up and en- forcement actions, including those imposed by the United States Federal Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA), also known as the Superfund law, or analogous state laws. CERCLA and similar state laws, in addition to other similar Canadian and U.S. laws, generally im- pose joint and several liability for clean-up and enforcement costs on current and former owners and operators of a site, as well as Canadian National Railway Company U.S. GAAP 2011 Annual Report 81 Notes to Consolidated Financial Statements 17 Major commitments and contingencies continued The Company anticipates that the majority of the liability at December 31, 2011 will be paid out over the next five years. However, some costs may be paid out over a longer period. The those whose waste is disposed of at the site, without regard to Company expects to partly recover certain accrued remediation fault or the legality of the original conduct. The Company has costs associated with alleged contamination and has recorded been notified that it is a potentially responsible party for study a receivable in Intangible and other assets for such recover- and clean-up costs at approximately 10 sites governed by the able amounts. Based on the information currently available, the Superfund law (and analogous state laws) for which investiga- Company considers its provisions to be adequate. tion and remediation payments are or will be made or are yet to be determined and, in many instances, is one of several poten- Unknown existing environmental concerns tially responsible parties. While the Company believes that it has identified the costs like- The ultimate cost of addressing these known contaminated ly to be incurred for environmental matters in the next several sites cannot be definitely established given that the estimated years based on known information, the discovery of new facts, environmental liability for any given site may vary depending on future changes in laws, the possibility of releases of hazardous the nature and extent of the contamination; the nature of antici- materials into the environment and the Company’s ongoing ef- pated response actions, taking into account the available clean- forts to identify potential environmental liabilities that may be up techniques; evolving regulatory standards governing environ- associated with its properties may result in the identification of mental liability; and the number of potentially responsible parties additional environmental liabilities and related costs. The mag- and their financial viability. As a result, liabilities are recorded nitude of such additional liabilities and the costs of complying based on the results of a four-phase assessment conducted on with future environmental laws and containing or remediating a site-by-site basis. A liability is initially recorded when environ- contamination cannot be reasonably estimated due to many fac- mental assessments occur, remedial efforts are probable, and tors, including: when the costs, based on a specific plan of action in terms of the (i) the lack of specific technical information available with re- technology to be used and the extent of the corrective action re- spect to many sites; quired, can be reasonably estimated. The Company estimates the (ii) the absence of any government authority, third-party orders, costs related to a particular site using cost scenarios established or claims with respect to particular sites; by external consultants based on the extent of contamination (iii) the potential for new or changed laws and regulations and and expected costs for remedial efforts. In the case of multiple parties, the Company accrues its allocable share of liability taking for development of new remediation technologies and uncer- tainty regarding the timing of the work with respect to par- into account the Company’s alleged responsibility, the number ticular sites; and of potentially responsible parties and their ability to pay their re- (iv) the determination of the Company’s liability in proportion to spective share of the liability. Adjustments to initial estimates are other potentially responsible parties and the ability to recover recorded as additional information becomes available. costs from any third parties with respect to particular sites. The Company’s provision for specific environmental sites is undiscounted and includes costs for remediation and restora- Therefore, the likelihood of any such costs being incurred or tion of sites, as well as monitoring costs. Environmental accruals, whether such costs would be material to the Company cannot which are classified as Casualty and other in the Consolidated be determined at this time. There can thus be no assurance that Statement of Income, include amounts for newly identified liabilities or costs related to environmental matters will not be in- sites or contaminants as well as adjustments to initial estimates. curred in the future, or will not have a material adverse effect on Recoveries of environmental remediation costs from other parties the Company’s financial position or results of operations in a par- are recorded as assets when their receipt is deemed probable. ticular quarter or fiscal year, or that the Company’s liquidity will As at December 31, 2011, 2010 and 2009, the Company’s not be adversely impacted by such liabilities or costs, although provision for specific environmental sites was as follows: In millions Balance January 1 Accruals and other Payments 2011 2010 2009 $ 150 $ 103 $ 125 17 (15) 67 (20) (7) (15) Balance December 31 $ 152 $ 150 $ 103 Current portion - Balance December 31 $ 63 $ 34 $ 38 management believes, based on current information, that the costs to address environmental matters will not have a material adverse effect on the Company’s financial position or liquidity. Costs related to any unknown existing or future contamination will be accrued in the period in which they become probable and reasonably estimable. 82 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements Future occurrences is less than the fair value, as estimated at the inception of the In railroad and related transportation operations, it is possible lease, then the Company must, under certain conditions, com- that derailments or other accidents, including spills and releas- pensate the lessor for the shortfall. At December 31, 2011, the es of hazardous materials, may occur that could cause harm to maximum exposure in respect of these guarantees was $112 mil- human health or to the environment. As a result, the Company lion. There are no recourse provisions to recover any amounts may incur costs in the future, which may be material, to address from third parties. any such harm, compliance with laws and other risks, including costs relating to the performance of clean-ups, payment of envi- (ii) Other guarantees ronmental penalties and remediation obligations, and damages As at December 31, 2011, the Company, including certain of its relating to harm to individuals or property. subsidiaries, has granted $499 million of irrevocable standby let- Regulatory compliance ters of credit and $10 million of surety and other bonds, issued by highly rated financial institutions, to third parties to indemnify The Company may incur significant capital and operating costs them in the event the Company does not perform its contractual associated with environmental regulatory compliance and clean- obligations. As at December 31, 2011, the maximum potential up requirements, in its railroad operations and relating to its liability under these guarantee instruments was $509 million, of past and present ownership, operation or control of real prop- which $439 million related to workers’ compensation and other erty. Operating expenses for environmental matters amounted to employee benefit liabilities and $70 million related to equip- $4 million in 2011, $23 million in 2010 and $11 million in 2009. ment under leases and other liabilities. The letters of credit were In addition based on the results of its operations and mainte- drawn on the Company’s bilateral letter of credit facilities. The nance programs, as well as ongoing environmental audits and Company has not recorded a liability in respect of these guaran- other factors, the Company plans for specific capital improve- tee instruments as they relate to the Company’s future perfor- ments on an annual basis. Certain of these improvements help mance. In addition, as the Company does not expect to make ensure facilities, such as fuelling stations and waste water and any payments under these guarantee instruments, the Company storm water treatment systems, comply with environmental stan- has not recorded an additional liability at December 31, 2011 dards and include new construction and the updating of exist- with respect to such guarantees as they relate to the Company’s ing systems and/or processes. Other capital expenditures relate future performance. The majority of the guarantee instruments to assessing and remediating certain impaired properties. The mature at various dates between 2012 and 2014. Company’s environmental capital expenditures amounted to $11 million in 2011, $14 million in 2010 and $9 million in 2009. (iii) General indemnifications E. Guarantees and indemnifications In the normal course of business, the Company has provided in- demnifications, customary for the type of transaction or for the In the normal course of business, the Company, including certain railway business, in various agreements with third parties, includ- of its subsidiaries, enters into agreements that may involve pro- ing indemnification provisions where the Company would be viding guarantees or indemnifications to third parties and others, required to indemnify third parties and others. Indemnifications which may extend beyond the term of the agreements. These are found in various types of contracts with third parties which include, but are not limited to, residual value guarantees on include, but are not limited to: operating leases, standby letters of credit and surety and other (a) contracts granting the Company the right to use or enter bonds, and indemnifications that are customary for the type of upon property owned by third parties such as leases, ease- transaction or for the railway business. ments, trackage rights and sidetrack agreements; The Company is required to recognize a liability for the fair (b) contracts granting rights to others to use the Company’s value of the obligation undertaken in issuing certain guarantees property, such as leases, licenses and easements; on the date the guarantee is issued or modified. In addition, (c) contracts for the sale of assets; where the Company expects to make a payment in respect of (d) contracts for the acquisition of services; a guarantee, a liability will be recognized to the extent that one (e) financing agreements; has not yet been recognized. (f) trust indentures, fiscal agency agreements, underwriting agree ments or similar agreements relating to debt or equity (i) Guarantee of residual values of operating leases securities of the Company and engagement agreements with The Company has guaranteed a portion of the residual values financial advisors; of certain of its assets under operating leases with expiry dates (g) transfer agent and registrar agreements in respect of the between 2012 and 2022, for the benefit of the lessor. If the fair Company’s securities; value of the assets, at the end of their respective lease term, Canadian National Railway Company U.S. GAAP 2011 Annual Report 83 Notes to Consolidated Financial Statements 17 Major commitments and contingencies continued 18 Financial instruments (h) trust and other agreements relating to pension plans and other plans, including those establishing trust funds to secure payment to certain officers and senior employees of special retirement compensation arrangements; (i) pension transfer agreements; (j) master agreements with financial institutions governing de- rivative transactions; (k) settlement agreements with insurance companies or other third parties whereby such insurer or third party has been indemnified for any present or future claims relating to insurance policies, incidents or events covered by the settlement agreements; and (l) acquisition agreements. A. Risk management In the normal course of business, the Company is exposed to vari- ous risks such as customer credit risk, commodity price risk, interest rate risk, foreign currency risk, and liquidity risk. To manage these risks, the Company follows a financial risk management frame- work, which is monitored and approved by the Company’s Finance Committee, with a goal of maintaining a strong balance sheet, op- timizing earnings per share and free cash flow, financing its opera- tions at an optimal cost of capital and preserving its liquidity. The Company has limited involvement with derivative financial instru- ments in the management of its risks and does not use them for trading purposes. At December 31, 2011, the Company did not have any significant derivative financial instruments outstanding. To the extent of any actual claims under these agreements, (i) Customer credit risk the Company maintains provisions for such items, which it con- In the normal course of business, the Company monitors the fi- siders to be adequate. Due to the nature of the indemnification nancial condition and credit limits of its customers and reviews clauses, the maximum exposure for future payments may be ma- the credit history of each new customer. Although the Company terial. However, such exposure cannot be reasonably determined. believes there are no significant concentrations of credit risk, eco- During the year, the Company entered into various indemni- nomic conditions can affect the Company’s customers and can fication contracts with third parties for which the maximum ex- result in an increase to the Company’s credit risk and exposure posure for future payments cannot be reasonably determined. As to business failures of its customers. To manage its credit risk on a result, the Company was unable to determine the fair value an ongoing basis, the Company’s focus is on keeping the average of these guarantees and accordingly, no liability was recorded. daily sales outstanding within an acceptable range and working There are no recourse provisions to recover any amounts from with customers to ensure timely payments, and in certain cases, third parties. requiring financial security, including letters of credit. (ii) Fuel The Company is exposed to commodity price risk related to pur- chases of fuel and the potential reduction in net income due to in- creases in the price of diesel. The impact of variable fuel expense is mitigated substantially through the Company’s fuel surcharge pro- gram which apportions incremental changes in fuel prices to ship- pers within agreed upon guidelines. While this program provides ef- fective coverage, residual exposure remains given that fuel price risk cannot be completely mitigated due to timing and given the volatil- ity in the market. As such, the Company may enter into derivative instruments to mitigate such risk when considered appropriate. (iii) Interest rate 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. Such risk exists in relation to the Company’s pension and postre- tirement plans and to its long-term debt. Overall return in the capi- tal markets and the level of interest rates affect the funded status of the Company’s pension plans, particularly the Company’s main Canadian pension plan. Adverse changes with respect to pension plan returns and the level of interest rates from the date of the last actuarial valuations may have a material adverse effect on the fund- ed status of the plans and on the Company’s results of operations. 84 2011 Annual Report U.S. GAAP Canadian National Railway Company Notes to Consolidated Financial Statements Notes to Consolidated Financial Statements The Company mainly issues fixed-rate debt, which exposes the (v) Liquidity risk Company to variability in the fair value of the debt. The Company The Company monitors and manages its cash requirements to also issues debt with variable interest rates through commercial ensure sufficient access to funds to meet operational and invest- paper borrowing and capital leases, which exposes the Company ing requirements. The Company pursues a solid financial policy to variability in interest expense. To manage its interest rate expo- framework with the goal of maintaining a strong balance sheet, sure, the Company manages its borrowings in line with liquidity by monitoring its adjusted debt-to-total capitalization and ad- needs, maturity schedule, and currency and interest rate profile. In justed debt-to-adjusted earnings before interest, income taxes, anticipation of future debt issuances, the Company may enter into depreciation and amortization (EBITDA) ratios, and preserving an forward rate agreements. The Company does not currently hold investment grade credit rating to be able to maintain access to any significant derivative financial instruments to manage its inter- public financing. est rate risk. At December 31, 2011, Accumulated other compre- The Company’s principal source of liquidity is cash generated hensive loss included an unamortized gain of $8 million, $6 million from operations, which is supplemented by its commercial paper after-tax ($10 million, $7 million after-tax at December 31, 2010) program to meet short-term liquidity needs. If the Company were relating to treasury lock transactions settled in a prior year, which to lose access to the program for an extended period of time, are being amortized over the term of the related debt. the Company could rely on its $800 million revolving credit facil- (iv) Foreign currency ity. The Company’s primary uses of funds are for working capital requirements, including income tax installments as they become The Company conducts its business in both Canada and the U.S. due and pension contributions, contractual obligations, capital ex- and as a result, is affected by currency fluctuations. Changes in penditures relating to track infrastructure and other, acquisitions, the exchange rate between the Canadian dollar and other curren- dividend payouts, and the repurchase of shares through a share cies (including the US dollar) make the goods transported by the buyback program, when applicable. The Company sets priorities Company more or less competitive in the world marketplace and on its uses of available funds based on short-term operational re- thereby further affect the Company’s revenues and expenses. quirements, expenditures to maintain a safe railway and strategic All of the Company’s U.S. operations are self-contained for- initiatives, while also considering its long-term contractual obliga- eign entities with the US dollar as their functional currency. tions and returning value to its shareholders. Accordingly, the U.S. operations’ assets and liabilities are translat- ed into Canadian dollars at the rate in effect at the balance sheet B. Fair value of financial instruments date and the revenues and expenses are translated at average ex- Generally accepted accounting principles define the fair value of change rates during the year. All adjustments resulting from the a financial instrument as the amount at which the instrument translation of the foreign operations are recorded in Other com- could be exchanged in a current transaction between willing par- prehensive income (loss). For the purpose of minimizing volatility ties. The Company uses the following methods and assumptions of earnings resulting from the conversion of US dollar-denominat- to estimate the fair value of each class of financial instruments ed long-term debt into the Canadian dollar, the Company des- for which the carrying amounts are included in the Consolidated ignates the US dollar-denominated long-term debt of the parent Balance Sheet under the following captions: company as a foreign currency hedge of its net investment in U.S. (i) Cash and cash equivalents, Restricted cash and cash equiva- subsidiaries. As a result, from the dates of designation, foreign lents, Accounts receivable, Other current assets, Accounts exchange gains and losses on translation of the Company’s US payable and other: dollar-denominated long-term debt are recorded in Accumulated The carrying amounts approximate fair value because of the other comprehensive loss. short maturity of these instruments. Occasionally, the Company enters into short-term foreign (ii) Intangible and other assets: exchange contracts as part of its cash management strategy. At Included in Intangible and other assets are equity investments December 31, 2011, the Company did not have any foreign ex- for which the carrying value approximates the fair value, with change contracts outstanding. the exception of certain cost investments for which the fair value was estimated based on the Company’s proportionate share of the underlying net assets. (iii) Debt: The fair value of the Company’s debt is estimated based on the quoted market prices for the same or similar debt instru- ments, as well as discounted cash flows using current interest rates for debt with similar terms, company rating, and remain- ing maturity. Canadian National Railway Company U.S. GAAP 2011 Annual Report 85 Notes to Consolidated Financial Statements 18 Financial instruments continued The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments as at December 31, 2011 and December 31, 2010 for which the carrying values on the Consolidated Balance Sheet are different from their fair values: In millions Financial assets Investments (Note 6) Financial liabilities Total debt (Note 9) December 31, 2011 December 31, 2010 Carrying amount Fair value Carrying amount Fair value $ 31 $ 126 $ 25 $ 114 $ 6,576 $ 7,978 $ 6,071 $ 6,937 19 Accumulated other comprehensive loss The components of Accumulated other comprehensive loss are as follows: In millions Foreign exchange loss Pension and other postretirement benefit plans Derivative instruments (Note 18) Accumulated other comprehensive loss December 31, 2011 2010 $ (769) $ (796) (2,076) 6 (920) 7 $ (2,839) $ (1,709) The components of Other comprehensive loss and the related tax effects are as follows: In millions Year ended December 31, 2011 2010 2009 Accumulated other comprehensive loss - Balance at January 1 $ (1,709) $ (948) $ (155) Other comprehensive income (loss): Foreign exchange gain (loss) (net of income tax (expense) recovery of $19, $(53) and $(131), for 2011, 2010 and 2009, respectively) Pension and other postretirement benefit plans (net of income tax (expense) recovery of $401, $241 and $223, for 2011, 2010 and 2009, respectively) Derivative instruments (net of income tax recovery of $1, nil and nil for 2011, 2010 and 2009, respectively) Other comprehensive loss 27 (68) (1,156) (692) (1) (1,130) (1) (761) (153) (640) - (793) Accumulated other comprehensive loss - Balance at December 31 $ (2,839) $ (1,709) $ (948) 20 Comparative figures Certain figures previously reported in 2010 and 2009 have been reclassified to conform with the basis of presentation adopted in 2011. 86 2011 Annual Report U.S. GAAP Canadian National Railway Company Corporate Governance – Delivering Responsibly CN is committed to being a good corporate citizen. At CN, sound We are proud of our corporate governance practices. For corporate citizenship touches nearly every aspect of what we more information on these practices, please refer to our website, do, from governance to business ethics, from safety to envi- as well as to our proxy circular – mailed to our shareholders and also ronmental protection. Central to this comprehensive approach is available on our website. CN understands that our long-term our strong belief that good corporate citizenship is simply good success is connected to our contribution to a sustainable future. business. That is why we are committed to the safety of our employees, the CN has always recognized the importance of good gov- public and the environment; delivering reliable, efficient service so ernance. As it evolved from a Canadian institution to a North our customers succeed in global markets; building stronger com- American publicly traded company, CN voluntarily followed cer- munities; and providing a great place to work. Our sustainability tain corporate governance requirements that, as a company activities are outlined in our Delivering Responsibly report, which based in Canada, it was not technically compelled to follow. We can be found on our website: www.cn.ca continue to do so today. Since many of our peers – and share- For the third straight year, CN’s practices have earned it a holders – are based in the United States, we want to provide the place on the Dow Jones Sustainability Index (DJSI) North America, same assurances of sound practices as our U.S. competitors. which includes an assessment of CN’s governance practices. Hence, we adopt and adhere to corporate governance CN received the Best Corporate Governance Award from practices that either meet or exceed applicable Canadian and IR Magazine in 2009 and 2010, and in 2011 we received the U.S. corporate governance standards. As a Canadian reporting Canadian Coalition for Good Governance Award for Best Disclosure issuer with securities listed on the Toronto Stock Exchange (TSX) of Board Governance Practices and Director Qualifications. and the New York Stock Exchange (NYSE), CN complies with ap- plicable rules adopted by the Canadian Securities Administrators and the rules of the U.S. Securities and Exchange Commission giving effect to the provisions of the U.S. Sarbanes-Oxley Act of 2002. As a Canadian company, we are not required to comply with many of the NYSE corporate governance rules, and instead may comply with Canadian governance practices. However, except as summarized on our website (www.cn.ca in the Delivering Responsibly – Governance section), our governance prac tices comply with the NYSE corporate governance rules in all signifi- cant respects. Consistent with the belief that ethical conduct goes be- yond compliance and resides in a solid governance culture, the Delivering Responsibly – Governance section on the CN website contains CN’s Corporate Governance Manual (including the char- ters of our Board and of our Board committees) and CN’s Code of Business Conduct. Printed versions of these documents are also available upon request to CN’s Corporate Secretary. Because it is important to CN to uphold the highest standards in corporate governance and that any potential or real wrongdo- ings be reported, CN has also adopted methods allowing employ- ees and third parties to report accounting, auditing and other concerns, as more fully described on our website. Canadian National Railway Company 2011 Annual Report 87 Shareholder and Investor Information Annual meeting Shareholder services The annual meeting of shareholders will be held at 10 a.m. ADT on April 24, 2012 at: The World Trade and Convention Centre Grand Ballroom, Room 200C 1800 Argyle Street Halifax, Nova Scotia, Canada Annual information form The annual information form may be obtained on CN's website (www.cn.ca) or by writing to: The Corporate Secretary Canadian National Railway Company 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 Transfer agent and registrar Computershare Trust Company of Canada Offices in: Montreal, QC; Toronto, ON; Calgary, AB; Vancouver, BC Telephone: 1-800-564-6253 www.computershare.com/investorcentrecanada Co-transfer agent and co-registrar Computershare Trust Company N.A. Att: Stock Transfer Department Overnight Mail Delivery: 250 Royall Street, Canton MA 02021 Regular Mail Delivery: P.O. Box 43070, Providence, RI 02940-3070 Telephone: 303-262-0600 or 1-800-962-4284 Shareholders having inquiries concerning their shares, wishing to obtain information about CN, or to receive dividends by direct deposit or in U.S. dollars may obtain detailed information by communicating with: Computershare Trust Company of Canada Shareholder Services 100 University Avenue, 9th Floor Toronto, Ontario M5J 2Y1 Telephone: 1-800-564-6253 www.computershare.com/investorcentrecanada Stock exchanges CN common shares are listed on the Toronto and New York stock exchanges. Ticker symbols: CNR (Toronto Stock Exchange) CNI (New York Stock Exchange) Investor relations Robert Noorigian Vice-President, Investor Relations Telephone: 514-399-0052 Head office Canadian National Railway Company 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 P.O. Box 8100 Montreal, Quebec H3C 3N4 Additional copies of this report are available from: CN Public Affairs 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 Telephone: 1-888-888-5909 Email: contact@cn.ca La version française du présent rapport est disponible à l’adresse suivante : Affaires publiques du CN 935, rue de La Gauchetière Ouest Montréal (Québec) H3B 2M9 Téléphone : 1-888-888-5909 Courriel : contact@cn.ca 88 2011 Annual Report Canadian National Railway Company Contents 1 A message from the Chairman 2 A message from Claude Mongeau 4 Operational and Service Excellence 6 Board of Directors 7 Financial Section (U.S. GAAP) 87 Corporate Governance – Delivering Responsibly 88 Shareholder and Investor Information Except where otherwise indicated, all ﬁ nancial information reﬂ ected in this document is expressed in Canadian dollars and determined on the basis of United States gener- ally accepted accounting principles (U.S. GAAP). Certain information included in this annual report constitutes “forward-looking statements” within the meaning of the United States Private Securities Litigation Reform Act of 1995 and under Canadian securities laws. CN cautions that, by their nature, these forward-looking statements involve risks, uncertainties and assumptions. The Company cautions that its assumptions may not materialize and that current economic conditions render such assumptions, although reasonable at the time they were made, subject to greater uncertainty. Such forward-looking statements are not guarantees of future performance and involve known and unknown risks, uncertainties and other factors which may cause the actual results or performance of the Company or the rail industry to be materially different from the outlook or any future results or performance implied by such statements. Important risk factors that could affect the forward-looking statements include, but are not limited to, the effects of general economic and business conditions, industry competition, inﬂ ation, currency and interest rate ﬂ uctuations, changes in fuel prices, legislative and/or regulatory developments, compliance with environmental laws and regulations, actions by regulators, various events which could disrupt operations, including natural events such as severe weather, droughts, ﬂ oods and earthquakes, labor negotiations and disruptions, environmental claims, uncertainties of investigations, proceedings or other types of claims and litigation, risks and liabilities arising from derailments, and other risks detailed from time to time in reports ﬁ led by CN with securities regulators in Canada and the United States. Reference should be made to “Manage- ment’s Discussion and Analysis” in CN’s annual and interim reports, Annual Information Form and Form 40-F ﬁ led with Canadian and U.S. securities regulators, available on CN’s website (www.cn.ca), for a summary of major risks. CN assumes no obligation to update or revise forward-looking statements to reﬂ ect future events, changes in circum- stances, or changes in beliefs, unless required by applicable Canadian securities laws. In the event CN does update any forward-looking statement, no inference should be made that CN will make additional updates with respect to that state- ment, related matters, or any other forward-looking statement. As used herein, the word “Company” or “CN” means, as the context requires, Canadian National Railway Company and/ or its subsidiaries. This report has been printed on FSC® paper. OPERATIONAL AND SERVICE EXCELLENCE 2 0 1 1 a n n u a l r e p o r t 935 de La Gauchetière Street West Montreal, Quebec H3B 2M9 www.cn.ca 2 0 1 1 a n n u a l r e p o r t

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