Norfolk Southern 10-K 2006
Documents found in this filing:
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive proxy statement to be filed electronically pursuant to Regulation 14A not later than 120 days after the end of the fiscal year, are incorporated by reference in Part III.
TABLE OF CONTENTS
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES (NS)
Norfolk Southern Corporation and Subsidiaries (NS)
Item 1. Business. and Item 2. Properties .
GENERAL - Norfolk Southern Corporation ( Norfolk Southern) was incorporated on July 23, 1980 , under the laws of the Commonwealth of Virginia . On June l, 1982, Norfolk Southern acquired control of two major operating railroads, Norfolk and Western Railway Company (NW) and Southern Railway Company (Southern) in accordance with an Agreement of Merger and Reorganization dated as of July 31, 1980, and with the approval of the transaction by the Interstate Commerce Commission (now the Surface Transportation Board [STB]). Effective Dec. 31, 1990 , Norfolk Southern transferred all the common stock of NW to Southern, and Southern's name was changed to Norfolk Southern Railway Company (Norfolk Southern Railway or NSR). Effective Sept. 1, 1998 , NW was merged with and into Norfolk Southern Railway. As of Dec. 31, 2005 , all the common stock of Norfolk Southern Railway was owned directly by Norfolk Southern.
Through a limited liability company, Norfolk Southern and CSX Corporation (CSX) jointly own Conrail Inc. (Conrail), whose primary subsidiary is Consolidated Rail Corporation (CRC). Norfolk Southern has a 58% economic and 50% voting interest in the jointly owned entity, and CSX has the remainder of the economic and voting interests. CRC owns and operates certain properties (the Shared Assets Areas) for the joint and exclusive benefit of NSR and CSX Transportation Inc. (CSXT). On June 1, 1999 , NSR and CSXT, began operating separate portions of Conrail’s rail routes and assets. On August 27, 2004, NS, CSX and Conrail completed a corporate reorganization of Conrail (Conrail Corporate Reorganization), which established direct ownership and control by NSR and CSX Transportation, Inc. (CSXT) of two former CRC subsidiaries, Pennsylvania Lines LLC (PRR) and New York Central Lines LLC (NYC), respectively (See Note 5 to the Consolidated Financial Statements).
Norfolk Southern makes available free of charge through its website, www.nscorp.com, its annual report on Form 10‑K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (SEC). Additionally, Norfolk Southern’s corporate governance guidelines, board committee charters, code of ethics and code of ethical conduct for senior financial officers are available on the company’s website and in print to any shareholder who requests them.
Unless otherwise indicated, Norfolk Southern and its subsidiaries are referred to collectively as NS.
RAILROAD OPERATIONS – As of Dec. 31, 2005 , NS’ railroads operated approximately 21,200 miles of road in 22 eastern states, the District of Columbia and Ontario , Canada . The miles
operated, which includes leased lines between Cincinnati , Ohio , and Chattanooga , Tennessee , and trackage rights over property owned by North Carolina Railway Company, were as follows:
NS' railroads carry raw materials, intermediate products and finished goods primarily in the Southeast, East and Midwest and, via interchange with other rail carriers, to and from the rest of the United States and parts of Canada . They also transport overseas freight through several Atlantic and Gulf Coast ports, which include:
The lines of NS' railroads reach most of the larger industrial and trading centers of the Southeast, Northeast, Mid-Atlantic region and Midwest . In addition, haulage arrangements with connecting carriers allow NS' railroads to provide single-line service to and from additional markets. Highlights of our service network are as follows:
Haulage, trackage rights and interline arrangements with:
The system’s lines also reach many individual industries, electric generating facilities, mines (in western Virginia , eastern Kentucky , southern and northern West Virginia and western Pennsylvania ), distribution centers, transload facilities and other business located in smaller communities in its service area.
Triple Crown Operations – Triple Crown Services Company (TCSC), NS’ subsidiary, offers door-to-door intermodal service using RoadRailer® equipment and domestic containers. RoadRailer® units are enclosed vans that can be pulled over highways in tractor-trailer configuration and over the rails by locomotives. TCSC provides intermodal service in major traffic corridors, including those between the Midwest and the Northeast, the Midwest and the Southeast, and the Midwest and Texas .
The following table sets forth certain statistics relating to NS railroads' operations for the past 5 years:
1 Includes $107 million of costs for a voluntary separation program, which added 1.6 percentage points to the ratio.
RAILWAY OPERATING REVENUES -- NS' total railway operating revenues were $8.5 billion in 2005. See the financial information by traffic segment in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”
COAL TRAFFIC -- Coal, coke and iron ore -- most of which is bituminous coal -- is NS' railroads' largest commodity group as measured by revenues. The railroads handled a total of 187 million tons in 2005, most of which originated on NS' lines in West Virginia , Virginia , Pennsylvania and Kentucky . Revenues from coal, coke and iron ore accounted for about 25% of NS' total railway operating revenues in 2005.
Total coal handled through all system ports in 2005 was 38 million tons. Of this total, 12 million tons (including coastwise traffic) moved through Norfolk , Virginia , 4 million tons moved through the Baltimore Terminal, 14 million tons moved to various docks on the Ohio River , and 8 million tons moved to various Lake Erie ports. Other than coal for export, virtually all coal handled by NS' railroads was terminated in states east of the Mississippi River .
See the discussion of coal traffic, by type of coal, in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.”
GENERAL MERCHANDISE TRAFFIC - General merchandise traffic is composed of five major commodity groupings: automotive; chemicals; metals and construction; agriculture, consumer products and government; and paper, clay and forest products. The automotive group includes finished vehicles for BMW, DaimlerChrysler, Ford Motor Company, General Motors, Honda, Isuzu, Jaguar, Land Rover, Mazda, Mercedes-Benz, Mitsubishi, Nissan, Saab, Subaru, Suzuki, Toyota and Volkswagen, and auto parts for Ford Motor Company, General Motors, Mercedes-Benz and Toyota . The chemicals group includes sulfur and related chemicals, petroleum products, chlorine and bleaching compounds, plastics, rubber, industrial chemicals, chemical wastes and municipal wastes. The metals and construction group includes steel, aluminum products, machinery, scrap metals, cement, aggregates, bricks and minerals. The agriculture, consumer products and government group includes soybeans, wheat, corn, fertilizer, animal and poultry feed, food oils, flour, beverages, canned goods, sweeteners, consumer products, ethanol and items for the military. The paper, clay and forest products group includes lumber and wood products, pulp board and paper products, wood fibers, wood pulp, scrap paper and clay.
In 2005, 144 million tons of general merchandise freight, or approximately 66% of total general merchandise tonnage handled by NS, originated online. The balance of general merchandise traffic was received from connecting carriers at interterritorial gateways. The principal interchange points for NS-received traffic included Chicago , Memphis , New Orleans , Cincinnati , Kansas City, Detroit , Hagerstown , St. Louis/East St. Louis and Louisville . General merchandise carloads handled in 2005 were 2.9 million, the revenue from which accounted for 54% of NS’ total railway operating revenues in 2005.
See the discussion of general merchandise rail traffic by commodity group in Part II, Item 7, “Management's Discussion and Analysis of Financial Conditions and Results of Operations.”
INTERMODAL TRAFFIC - The intermodal market consists of shipments moving in trailers, domestic and international containers, and Roadrailer® equipment. These shipments are handled on behalf of intermodal marketing companies, international steamship lines, truckers and other shippers. Intermodal units handled in 2005 were 3.2 million, the revenues from which accounted for 21% of NS’ total railway operating revenues for the year.
See the discussion of intermodal traffic in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.”
FREIGHT RATES - In 2005, NS' railroads continued their reliance on private contracts and exempt price quotes as their predominant pricing mechanisms. Thus, a major portion of NS' railroads' freight business is not currently economically regulated by the government. In general, market forces have been substituted for government regulation and now are the primary determinant of rail service prices. In 2005, coal movements that had been moving under common carrier (tariff) rates to Duke Energy and Carolina Power and Light power plants began moving under contract rates as part of the settlement agreements resolving the rail transportation rate cases brought by each of the utilities. In 2004 there were significant coal movements moving under common carrier (tariff) rates that had previously moved under rates contained in transportation contracts.
In 2005, NS' railroads were found by the STB to be “revenue adequate” based on results for the year 2004. A railroad is “revenue adequate” under the applicable law when its return on net investment exceeds the rail industry's composite cost of capital. This determination is made pursuant to a statutory requirement.
PASSENGER OPERATIONS - Regularly scheduled passenger trains are operated by Amtrak on NS' lines between Alexandria and New Orleans , between Greensboro and Selma , North Carolina , between Chicago , Illinois , and Detroit , Michigan , and between Chicago and Harrisburg , Pennsylvania . Commuter trains are operated on the NS line between Manassas and Alexandria in accordance with contracts with two transportation commissions of the Commonwealth of Virginia . NS also leases the Chicago to Manhattan , Illinois , line to the Commuter Rail Division of the Regional Transportation Authority of Northeast Illinois. NS operates lines on which Amtrak conducts regularly scheduled passenger operations. In addition, NS provides freight service over lines with significant ongoing Amtrak and commuter passenger operations, and is conducting freight operations over some trackage owned by Amtrak or by New Jersey Transit, the Southeastern Pennsylvania Transportation Authority, Metro-North Commuter Railroad Company and Maryland DOT. Finally, passenger operations are conducted either by Amtrak or by the commuter agencies over trackage owned by Conrail in the Shared Assets Areas.
NONCARRIER OPERATIONS - NS' noncarrier subsidiaries engage principally in the acquisition, leasing and management of coal, oil, gas and minerals; the development of commercial real estate; telecommunications; and the leasing or sale of rail property and equipment. In 2005, no such noncarrier subsidiary or industry segment grouping of noncarrier subsidiaries met the requirements for a reportable business segment set forth in Statement of Financial Accounting Standards No. 131.
The NS railroad system extends across 22 states, the District of Columbia and portions of Canada . The railroad infrastructure makes the company capital intensive with total property of approximately $21 billion.
Capital Expenditures - Capital expenditures for road, equipment and other property for the past five years were as follows (including capitalized leases):
Capital spending and maintenance programs are and have been designed to assure the ability to provide safe, efficient and reliable transportation services. For 2006, NS has budgeted $1.15 billion of capital spending. On Dec. 2, 2005 , NS announced an agreement to form a joint venture with Kansas City Southern pursuant to which NS intends to contribute $300 million in cash in exchange for a 30% interest in the joint venture. See the discussion following “Cash used for investing activities,” in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.”
Equipment - As of Dec. 31, 2005 , NS owned or leased the following units of equipment:
The following table indicates the number and year built for locomotives and freight cars owned at Dec. 31, 2005 .
* Fifty of the locomotives built in 2001 were purchased in 2002.
The following table shows the average age of NS’ locomotive and freight car fleets at Dec. 31, 2005 , and the number of retirements in 2005:
Between 1988 and 2000, about 29,000 coal cars were rebodied. As a result, the remaining serviceability of the freight car fleet is greater than may be inferred from the high percentage of freight cars built in earlier years.
Ongoing freight car and locomotive maintenance programs are intended to ensure the highest standards of safety, reliability, customer satisfaction and equipment marketability. The freight car bad order ratio rose in 2001 and 2002 as a result of decreased maintenance activity. The declines in 2005 and 2003 reflected an increase in maintenance activity as well as the retirement of unserviceable units. The locomotive bad order ratio includes units out of service for required inspections every 92 days and program work such as overhauls. The elevated ratio through 2005 reflected units out of service related to the resumption of maintenance and modification activities.
Encumbrances - Certain railroad equipment is subject to the prior lien of equipment financing obligations amounting to approximately $650 million as of Dec. 31, 2005 , and $930 million as of Dec. 31, 2004 .
Track Maintenance - Of the approximately 38,000 total miles of track operated, NS had responsibility for maintaining about 30,000 miles of track with the remainder being operated under trackage rights.
Over 75% of the main line trackage (including first, second, third and branch main tracks, all excluding trackage rights) has rail ranging from 131 to 155 pounds per yard with the standard installation currently at 136 pounds per yard. Approximately 44% of NS lines carried 20 million or more gross tons per track mile.
The following table summarizes several measurements regarding NS' track roadway additions and replacements during the past five years:
Microwave System - The NS microwave system, consisting of approximately 7,400 radio route miles, 424 core stations, 14 secondary stations and 5 passive repeater stations, provides communications between most operating locations. The microwave system is used primarily for voice communications, VHF radio control circuits, data and facsimile transmissions, traffic control operations and AEI data transmissions.
Traffic Control - Of the approximately 16,200 route miles owned by NS, 11,052 miles are signalized, including 8,030 miles of centralized traffic control (CTC) and 3,022 miles of automatic block signals. Of the 8,030 miles of CTC, 2,715 miles are controlled by data radio originating at 215 base station radio sites.
Computers - A computer network consisting of a centralized data center in Atlanta , Georgia , and various distributed computers throughout the company connects the yards, terminals, transportation offices, rolling stock repair points, sales offices and other key system locations. Operating and traffic data are processed and stored to provide customers with information on their shipments throughout the system. Computer systems provide current information on the location of every train and each car on line, as well as related waybill and other train and car movement data. In addition, the computer systems are utilized to assist management in the performance of a variety of functions and services including payroll, car and revenue accounting, billing, material management activities and controls, and special studies.
ENVIRONMENTAL MATTERS - Compliance with federal, state and local laws and regulations relating to the protection of the environment is a principal NS goal. To date, such compliance has not affected materially NS' capital additions, earnings, liquidity or competitive position. See the discussion of “Personal Injury, Environmental and Legal Liabilities” in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations,” and in Note 18 to the Consolidated Financial Statements.
EMPLOYEES – The following table shows the average number of employees and the average cost per employee for wages and benefits:
Approximately 85% of NS' railroad employees are covered by collective bargaining agreements with 14 different labor unions. See the discussion of “Labor Agreements” in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations.”
GOVERNMENT REGULATION - In addition to environmental, safety, securities and other regulations generally applicable to all businesses, NS' railroads are subject to regulation by the STB. The STB has jurisdiction over some rates, routes, conditions of service and the extension or abandonment of rail lines. The STB also has jurisdiction over the consolidation, merger or acquisition of control of and by rail common carriers. The Federal Railroad Administration regulates certain track and mechanical equipment standards.
The relaxation of economic regulation of railroads, begun over two decades ago under the Staggers Rail Act of 1980, has continued. Significant exemptions are TOFC/COFC (i.e., “piggyback”) business, rail boxcar traffic, lumber, manufactured steel, automobiles and certain bulk commodities such as sand, gravel, pulpwood and wood chips for paper manufacturing. Transportation contracts on regulated shipments effectively remove those shipments from regulation as well for the duration of the contract. About 80% of NS' freight revenues come from either exempt traffic or traffic moving under transportation contracts.
Efforts may be made in 2006 to re-subject the rail industry to unwarranted federal economic regulation. The Staggers Rail Act of 1980, which substantially reduced such regulation, encouraged and enabled rail carriers to innovate and to compete for business, thereby contributing to the economic health of the nation and to the revitalization of the industry. Accordingly, NS will oppose efforts to reimpose unwarranted economic regulation.
COMPETITION - There is continuing strong competition among rail, water and highway carriers. Price is usually only one factor of importance as shippers and receivers choose a transport mode and specific hauling company. Inventory carrying costs, service reliability, ease of handling and the desire to avoid loss and damage during transit are also important considerations, especially for higher-valued finished goods, machinery and consumer products. Even for raw materials, semifinished goods and work-in-process, users are increasingly sensitive to transport arrangements that minimize problems at successive production stages.
NS' primary rail competitor is the CSX system; both operate throughout much of the same territory. Other railroads also operate in parts of the territory. NS also competes with motor carriers, water carriers and with shippers who have the additional option of handling their own goods in private carriage.
Certain marketing strategies among railroads and between railroads and motor carriers enable carriers to compete more effectively in specific markets.
Item 1A. Risk Factors.
NS is subject to significant governmental regulation and legislation over commercial, environmental and operating matters. Railroads are subject to commercial regulation by the Surface Transportation Board, which has jurisdiction over some rates, routes, conditions of service and the extension or abandonment of rail lines. The STB also has jurisdiction over the consolidation, merger or acquisition of control of and by rail common carriers. Occasional efforts are made to re-subject the rail industry to unwarranted federal economic regulation. Economic re-regulation of the rail industry could negatively impact NS’ ability to determine prices for rail services and reduce capital spending on its rail network, resulting in a material adverse effect on NS’ results of operations, financial condition, and liquidity.
NS’ operations are subject to extensive federal, state, and local environmental laws and regulations concerning, among other things, emissions to the air; discharges to water ways or ground water supplies; handling, storage, transportation, and disposal of waste and other materials; and the cleanup of hazardous material or petroleum releases. The risk of incurring environmental liability - for acts and omissions, past, present and future - is inherent in the railroad business. Several of NS’ subsidiaries own, or have owned, land used as operating property or held for sale, or which is leased or may have been leased and operated by others. Environmental problems that are latent or undisclosed may exist on these properties, and NS could incur environmental liabilities or costs, the amount and materiality of which cannot be estimated reliably at this time, with respect to one or more of these properties. Moreover, lawsuits and claims involving other unidentified environmental sites and matters are likely to arise from time to time, and the resulting liabilities could have a significant effect on financial condition, results of operations or liquidity in a particular year or quarter.
The Federal Railroad Administration regulates a host of operations matters including track and mechanical equipment standards; signaling systems; testing and inspection of grade crossing warning devices, hours of service of operating employees; drug and alcohol testing; locomotive engineer certification; and reporting of employee injuries, among other areas. NS’ unintentional failure to comply with applicable laws and regulations could have a material adverse effect on NS, and changes in the legislative or regulatory frameworks within which NS operates could adversely affect its business.
NS may be affected by general economic conditions. Prolonged negative changes in domestic and global economic conditions affecting the producers and consumers of the commodities NS carries may have an adverse effect on its operating results, financial condition, and liquidity. Economic conditions resulting in bankruptcies of one or more large customers could have a significant impact in a particular quarter.
NS faces competition from other transportation providers. NS is subject to competition from motor carriers, railroads, and to a lesser extent, ships, barges, and pipelines on the basis of transit time, pricing, and the quality and reliability of service. While NS has used primarily internal resources to build or acquire and maintain its rail system, trucks and barges have been able to use public rights-of-way maintained by public entities. Any future improvements or expenditures materially increasing the quality or reducing the cost of alternative modes of transportation in the regions in which NS operates, or legislation granting materially greater latitude for motor carriers with respect to size or weight limitations, could have a material adverse effect on its results of operations, financial condition, and liquidity.
NS, as a common carrier by rail, must offer to transport hazardous materials, regardless of risk. Transportation of certain hazardous materials could create catastrophic losses in terms of personal injury and property damage costs, and compromise critical parts of our rail network. Legislation introduced in Congress in early 2005 would give federal regulators increased authority to conduct investigations and levy substantial fines and penalties in connection with railroad accidents. Federal regulators also would be required to prescribe new regulations governing railroads’ transportation of hazardous materials. If enacted, such legislation and regulations could impose significant additional costs on railroads. Additionally, regulations adopted by t he Department of Transportation and regulations contemplated by the Department of Home land Security could significantly increase the costs associated with moving hazardous materials on NS’ lines. Further, certain local governments have sought to enact ordinances banning hazardous materials moving by rail within their borders. Some legislators have contemplated pre-notification requirements for hazardous materials shipments. If promulgated such ordinances could require the re-routing of hazardous materials shipments, with the potential for significant additional costs and network inefficiencies.
The operations of carriers with which NS interchanges may adversely affect its operations. NS’ ability to provide rail service to customers in the U.S. and Canada depends in large part upon its ability to maintain cooperative relationships with connecting carriers with respect to, among other matters, freight rates, revenue divisions, car supply, reciprocal switching, interchange, trackage rights and locomotive availability. Deterioration in the operations of, or service provided by connecting carriers, or in our relationship with those connecting carriers, could result in NS’ inability to meet its customers’ demands or require NS to use alternate train routes, which could result in significant additional costs and network inefficiencies.
NS relies on technology and technology improvements in its business operations. If NS experiences significant disruption or failure of one or more of its information technology systems, including computer hardware, software, and communications equipment, NS could experience a service interruption, security breach, or other operational difficulties, which could have a material adverse impact on its results of operations, financial condition, and liquidity. Additionally, if NS does not have sufficient capital to acquire new technology or if it is unable to implement new technology, NS may suffer a competitive disadvantage within the rail industry and with companies providing other modes of transportation service, which could have a material adverse effect on its results of operations, financial position, and liquidity.
During 2006, NS will relocate its primary production data center to a newly renovated, state-of-the-art data center. Relocation of primary production applications will begin in April and continue through November. Multiple strategies are being utilized to minimize risk such as purchasing seed equipment for the new data center in support of all mission critical applications. This would include all network components, Mainframe, Teradata and server based critical infrastructure. For less critical applications, the equipment will be shutdown and transported to the new data center. In all cases disaster recovery readiness for mission critical applications will be maintained.
The vast majority of NS employees belong to labor unions, and labor agreements, strikes, or work stoppages could adversely affect its operations. A pproximately 26,000, or about 85%, of NS railroad employees are covered by collective bargaining agreements with various labor unions. If unionized workers were to engage in a strike, work stoppage, or other slowdown, NS could experience a significant disruption of its operations. Additionally, future national labor agreements, or renegotiation of labor agreements or provisions of labor agreements, could significantly increase NS’ costs for healthcare, wages, and other benefits. Any of these factors could have a material adverse impact on NS’ results of operations, financial condition, and liquidity.
NS may be subject to various claims and lawsuits that could result in significant expenditures. The nature of NS’ business exposes it to the potential for various claims and litigation related to labor and employment, personal injury, freight loss and other property damage, and other matters. Job-related personal injury and occupational claims are subject to the Federal Employers’ Liability Act (FELA), which is applicable only to railroads. FELA’s fault-based tort system produces results that are unpredictable and inconsistent as compared with a no-fault worker’s compensation system. The variability inherent in this system could result in actual costs being very different from the liability recorded.
Any material changes to current litigation trends or a catastrophic rail accident involving any or all of freight loss or property damage, personal injury, and environmental liability could have a material adverse effect on NS’ operating results, financial condition, and liquidity to the extent not covered by insurance. NS has obtained commercial insurance for potential losses for third-party liability and first-party property damages. Specified levels of risk are retained on a self-insurance basis (currently up to $25 million per occurrence for bodily injury and property damage to third parties and $12.5 million per occurrence for property owned by NS or in its care, custody or control). Insurance is available from a limited number of insurers and may not continue to be available or, if available, may not be obtainable on terms acceptable to NS.
Severe weather could result in significant business interruptions and expenditures. Severe weather conditions and other natural phenomena, including hurricanes and floods, may cause significant business interruptions and result in increased costs, increased liabilities, and decreased revenues, which could have an adverse effect on NS’ operating results, financial condition, and liquidity.
Unpredictability of demand for rail services resulting in the unavailability of qualified personnel could adversely affect NS’ operational efficiency and ability to meet demand. Workforce demographics, training requirements, and the availability of qualified personnel, particularly engineers and trainmen, could each have a negative impact on NS’ ability to meet demand for rail service. Unpredictable increases in demand for rail services may exacerbate such risks, which could have a negative impact on NS’ operational efficiency and otherwise have a material adverse effect on its results of operations, financial condition, and liquidity.
NS may be affected by terrorism or war. Any terrorist attack, or other similar event, any government response thereto, and war or risk of war could cause significant business interruption and may adversely affect NS’ results of operations, financial condition, and liquidity. Because NS plays a critical role in the nation’s transportation system, it could become the target of such an attack or have a significant role in the government’s preemptive approach or response to an attack or war.
Although NS currently maintains insurance coverage for third-party liability arising out of war and acts of terrorism, its current insurance coverage for first-party property damage and damage to property in NS’ care, custody or control does not apply to damage caused by war and may not apply to certain acts of terrorism. In addition, premiums for some or all of NS’ current insurance programs covering these losses could increase dramatically, or insurance coverage for certain losses may not be available to NS in the future.
NS may be affected by supply constraints resulting from disruptions in the fuel markets or the nature of some of its supplier markets. NS consumes over 500 million gallons of diesel fuel each year. Fuel availability could be affected by any limitation in the fuel supply or by any imposition of mandatory allocation or rationing regulations. If a severe fuel supply shortage arose from production curtailments, disruption of oil imports, disruption of domestic refinery production, damage to refinery or pipeline infrastructure, political unrest, war or otherwise, NS’ operating results, financial condition, and liquidity could be affected. Also, such an event would impact NS as well as its customers and other transportation companies.
Due to the capital intensive nature and industry-specific requirements of the rail industry, there are high barriers of entry for potential new suppliers of core railroad items, such as locomotives and rolling stock equipment. Additionally, NS competes with other industries for available capacity and raw materials used in the production of certain track materials, such as rail and ties. Changes in the competitive landscapes of these limited-supplier markets could result in increased prices or material shortages that could materially affect NS’ operating results, financial condition, and liquidity.
Item 1B. Unresolved Staff Comments.
Item 3. Legal Proceedings .
Item 4. Submission of Matters to a Vote of Security Holders .
There were no matters submitted to a vote of security holders during the fourth quarter of 2005.
Executive Officers of the Registrant.
Norfolk Southern's executive officers generally are elected and designated annually by the Board of Directors at its first meeting held after the annual meeting of stockholders, and they hold office until their successors are elected. Executive officers also may be elected and designated throughout the year as the Board of Directors considers appropriate. There are no family relationships among the officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. The following table sets forth certain information, as of January 31, 2006 , relating to the executive officers.
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES (NS)
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters .
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES
STOCK PRICE AND DIVIDEND INFORMATION
The Common Stock of Norfolk Southern Corporation, owned by 48,180 stockholders of record as of Dec. 31, 2005 , is traded on the New York Stock Exchange with the symbol NSC. The following table shows the high and low sales prices as reported by Bloomberg L.P. on its internet-based service and dividends per share, by quarter, for 2005 and 2004.
ISSUER REPURCHASES OF EQUITY SECURITIES
(1) Shares tendered by employees in connection with the exercise of stock options under the Long-Term Incentive Plan.
(2) On Nov. 22, 2005 , the Board of Directors authorized a share repurchase program, pursuant to which up to 50 million of the NS’ common stock may be purchased by 2015.
Item 6. Selected Financial Data .
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES
FIVE-YEAR FINANCIAL REVIEW 2001-2005
Item 7 . Management's Discussion and Analysis of Financial Condition and Results of Operations.
Norfolk Southern Corporation and Subsidiaries
Management's Discussion and Analysis of
Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes and the Selected Financial Data.
NS’ results in 2005 reflect substantial increases in revenues resulting from higher pricing, fuel surcharges and increased traffic volume that kept pace with the growth of the U.S. economy. Revenues increased $1.2 billion, or 17%, in 2005, as high demand for rail freight transportation, coupled with constrained capacity for other modes of transport and the fluidity of the NS network enabled NS to raise rates and handle additional volume. Approximately one-third of the revenue increase was due to higher fuel surcharge amounts. Carloadings were up 322,300 units, or 4%, largely because of a 9% increase in intermodal traffic. For the most part, increased operating expenses of $800 million were reflective of the increased traffic volume as well as sharply higher fuel prices. In addition, casualties and other claims expenses were significantly higher in 2005 related to an accident in Graniteville , South Carolina in January, a large unfavorable jury award in July and two strong Gulf Coast hurricanes in August and September. Despite the 14% increase in expenses, the operating ratio, a measure of the amount of operating revenues consumed by operating expenses, improved to 75.2%, and income from railway operations rose 24%.
The strong operating results translated into significantly improved cash flows which were used to pay off debt and increase dividends while establishing an all-time high cash and short-term investment balance of $1.3 billion at year end. Looking ahead, NS expects business levels to continue to grow in 2006 but at a more modest pace than seen in 2005. NS plans to continue its focus on improving service levels and maintaining an aggressive pricing strategy as business is renewed. Approximately one-half of NS’ revenue base is subject to renegotiation or repricing in 2006.
SUMMARIZED RESULTS OF OPERATIONS
2005 Compared with 2004
Net income in 2005 was $1.3 billion, or $3.11 per diluted share, up $358 million, or 39%, compared with $923 million, or $2.31 per diluted share, in 2004. The results in 2005 reflected a $96 million second quarter increase to net income related to state tax law changes (see Note 3), while the results in 2004 reflected a $53 million net gain related to the Conrail Corporate Reorganization (see Note 5). The remaining $315 million increase in net income was primarily due to higher income from railway operations. Railway operating revenues increased $1.2 billion, reflecting higher rates (including the favorable effects of the coal rate cases settled in the second quarter – see below), fuel surcharges and increased traffic volume. Railway operating expenses rose $800 million, or 14%, principally due to higher diesel fuel prices, increased volume-related expenses and casualty claims costs.
2004 Compared with 2003
Net income in 2004 of $923 million, or $2.31 per diluted share, was up $388 million, or 73%, compared with net income of $535 million, or $1.37 per diluted share, in 2003. Results in 2003 included a $10 million, or 3 cents per share, gain from discontinued operations (see Note 17) and a $114 million, or 29 cents per share, benefit related to the cumulative effect of changes in accounting principles (see Note 1). Income from continuing operations before accounting changes was $923 million, or $2.31 per diluted share, in 2004, compared with $411 million, or $1.05 per diluted share, in 2003. The increase in 2004 was the result of higher income from railway operations and also included a $53 million net noncash gain from the Conrail Corporate Reorganization (see Note 5). In addition, the comparisons were affected by the costs of a voluntary separation program (see Note 11) and the impairment of certain telecommunications assets (see Note 6) in 2003, which combined to reduce net income in that year by $119 million, or 30 cents per diluted share.
DETAILED RESULTS OF OPERATIONS
Railway Operating Revenues
Railway operating revenues were $8.5 billion in 2005, $7.3 billion in 2004 and $6.5 billion in 2003. The following table presents a three-year comparison of revenues, volume and average revenue per unit by market group.
In 2005, revenues increased $1.2 billion, or 17%, reflecting a $539 million, or 13%, rise in general merchandise revenues; a $387 million, or 22%, improvement in coal revenues; and a $289 million, or 19%, increase in intermodal revenues. All market groups collected significant amounts of fuel surcharge, which accounted for approximately one-third of the increase in revenues. At year end 2005, fuel surcharge provisions covered approximately 85% of total revenues.
As shown in the following table, the 2005 revenue improvement was the result of increased average revenues and higher traffic volumes.
The favorable revenue per unit/mix variance accounted for 74% of the total variance and was driven by higher rates and increased fuel surcharges, offset in part by an unfavorable mix component reflecting a 9% rise in lower average priced intermodal traffic volume. Volume rose by 322,300 units, or 4%.
In 2004, revenues increased $844 million, or 13%, reflecting a $318 million, or 9%, rise in general merchandise revenues, a $298 million, or 24%, increase in intermodal revenues and a $228 million, or 15%, improvement in coal revenues. The revenue improvement was the result of 9% higher traffic volumes and increased average revenues. All general merchandise market groups except automotive posted volume increases over 2003. The favorable revenue per unit/mix variance was driven by higher average revenue per unit that reflected higher rates and increased fuel surcharges, offset in part by the effects of a 17% increase in lower-priced intermodal traffic volume.
Beginning March 1, 2004 , NS modified its fuel surcharge program for its merchandise and coal traffic. The fuel surcharge program in effect until that time applied a 2% fuel surcharge to line haul freight charges when the West Texas Intermediate (WTI) crude oil price, as published in the Wall Street Journal, exceeded $28.00 per barrel for 30 consecutive business days. For each $5.00 per barrel increase, an additional 2% fuel surcharge applied. The revised fuel surcharge is based on the monthly average price of WTI crude oil. Line haul freight charges are adjusted by 0.4% for every dollar the average price exceeds $23 per barrel in the second calendar month prior to the month in which the fuel surcharge is applied. The modification in the fuel surcharge program causes the amount charged to more closely reflect fuel price fluctuations. Higher average WTI crude oil prices resulted in an increase in fuel surcharges; however, this was offset by the effect of higher prices for diesel fuel and other oil products.
COAL revenues increased $387 million, or 22%, compared with 2004, reflecting higher average revenue per carload and increased traffic volume. Coal average revenue per unit was up 19% compared with 2004, reflecting higher rates, the favorable effects of fuel surcharges, longer-haul business and the rate cases settled in the second quarter (see below). Coal represented 25% of NS’ revenues in 2005, and 83% of shipments handled originated on NS’ lines. Traffic volumes rose 3% primarily because of increased shipments of utility coal that offset lower export and domestic metallurgical coal, coke and iron ore shipments.
During the second quarter of 2005, NS entered into settlement agreements with two utility customers that resolved their rail transportation rate cases before the Surface Transportation Board (STB). In 2002, Duke Energy (Duke) and Carolina Power & Light (CP&L) each filed rate reasonableness complaints with the STB. In October 2004, the STB found NS’ rates to be reasonable in both cases, and at the STB’s invitation, Duke and CP&L each initiated proceedings to determine if phasing constraints should apply. As a result of the settlement of these cases, NS recognized $55 million of additional coal revenue related to the period in dispute.
In 2004, coal revenues increased $228 million, or 15%, versus 2003. Traffic volume increased 5% primarily due to higher export, utility and metallurgical coal volumes, which offset declines in coke and iron ore. Average revenue per unit increased 10%, reflecting higher rates, fuel surcharges, a favorable change in the mix of traffic (the rate of increase in longer haul traffic exceeded that of short haul traffic) and improved loading productivity (increased tons per car). Coal, coke and iron ore revenues represented 24% of total railway operating revenues in 2004, and 83% of NS' coal shipments originated on lines it operates.
Utility coal volume increased 6%, compared to 2004, in response to increased coal-fired generation to meet the heavier electricity demand of a strong economy, limited nuclear power generation capacity, higher natural gas prices and utility coal stockpiles which were below target levels across NS’ service area. Supply constraints dampened shipments while the increased demand for Eastern U.S. coal prompted some customers to shift to coal from non-traditional sources in Wyoming and Colorado and imported coal. Appalachian coal production increased modestly and western coal production was up 2% in 2005.
In 2004, utility coal volume increased 3%, compared to 2003, as electricity production was up almost 2% in NS’ service region responding to higher demand driven by a rebounding U.S. economy. Utilities increased burn to meet the heavier electricity demand and a new rail unloading facility began operating in April 2004 at a northern utility. Utility coal stockpiles were below target levels across NS’ service area due in part to the increased demand for coal-fired electric generation. Increased demand for Eastern U.S. coal prompted some customers to shift to coal from non-traditional sources in Wyoming and Colorado in addition to more imported coal. In response, Appalachian coal production increased slightly in 2004 following a decline in 2003.
The outlook for utility coal remains positive. The continued growth in demand for electricity and lower-than-targeted coal stockpiles at the utilities should support increased coal carloads in 2006. Domestic western origin and imported coals are expected to continue to be an important source of additional coal supply to overcome the supply imbalance created by increased utility demand and the supply constraints of Eastern U.S. coal sources. Natural gas prices are expected to remain higher and more volatile than coal energy prices. As always, demand for coal will be influenced by the weather.
A number of evolving environmental issues could affect the utility coal market, depending upon their outcome. These include a national energy policy, proposed multi-emissions legislation, mercury emissions standards, new source review, potential regional programs aimed at capping and reducing power plant CO 2 emissions, and ongoing efforts at addressing climate change. Certain utilities have chosen to add emissions control technologies to their electric generating units in advance of governmental requirements and are moving up their plans to more fully utilize their existing coal-fired power plants.
Export coal volume decreased 11% in 2005, compared to 2004, due to both coal supply constraints and a weak European steel market. Volume through Norfolk and Baltimore decreased. Norfolk was down approximately 16,000 carloads, or 14%, and Baltimore was down approximately 2,000 carloads, or 6%. U.S. exports in 2005 were constrained by several factors: (1) the tight coal supply from Eastern coal mines caused primarily by the sporadic closure of a major coal mine, (2) the idling of production by European steel manufacturers in order to manage finished goods inventory, and (3) the abundant supply of Chinese coke on the world market lowering the price and making it more economical to buy coke rather than import metallurgical coal from the U.S. and convert it.
In 2004, export coal volume increased 35%, compared to 2003, due to sustained strong global demand for high quality metallurgical coal and China ’s continued growing consumption of coal for steel production and electricity generation. The devaluation of the dollar resulted in lower U.S. coal prices relative to Australian and Canadian coal prices, which made U.S. coals more economical in traditional European markets. In addition, ocean vessel rates continued to favor U.S. coals. Volume through Baltimore and Norfolk increased dramatically. Baltimore was up approximately 24,000 carloads, or 159%, and Norfolk was up approximately 16,000 carloads, or 16%. However, U.S. exports in 2004 were constrained by the tight coal supply from Eastern coal mines.
Export coal volume for 2006 is expected to show improvement, subject to the availability of U.S. coal, as the European steel market recovers; and international demand for high-quality metallurgical coal is expected to remain high despite the impact of abundant Chinese coke on the world market.
Domestic metallurgical coal, coke and iron ore volume was down 2% in 2005, compared with 2004. Declines in domestic coke and iron ore volumes, principally due to the idling of a major steel blast furnace, were partially offset by an 8% increase in metallurgical coal.
For 2004, domestic metallurgical coal, coke and iron ore volume was flat compared with 2003. Metallurgical coal volume was up 12%. However, this was offset by declines in domestic coke and iron ore volumes, principally due to reduced production at an NS-served producer.
Demand for domestic metallurgical coal, coke and iron ore is expected to improve in 2006, as the idled blast furnace is expected to return to operation and metallurgical coal production is expected to grow.
Other coal volumes (principally steam coal shipped to industrial plants) decreased 3% versus 2004, primarily due to the diversion of coal to the utility market. In 2004, other coal volumes increased 2% versus 2003, primarily due to new business and the recovery of the U.S. economy.
GENERAL MERCHANDISE revenues increased 13% due to higher average rates and fuel surcharges. Traffic volume was up modestly compared with 2004 as decreases in automotive and chemicals traffic offset increases in other business groups. In 2004, general merchandise revenues increased 9% and traffic volume increased 4% compared to 2003, principally due to higher average revenues across all business groups, including increased fuel surcharges, and improved volumes in all but the automotive business group.
Automotive revenues rose 5% in 2005 compared with 2004, the result of an 8% increase in average revenue per unit that reflected pricing improvements and higher fuel surcharges. In contrast, traffic volume decreased 3% primarily due to reduced production at Ford and GM, with GM closing assembly plants in Michigan , Maryland and New Jersey . Ford and GM combined operate 17 of 31 assembly plants served by NS. These declines were partially offset by increased production at Honda, Mercedes-Benz and Toyota .
In 2004, automotive revenues increased 2%, reflecting pricing improvements and fuel surcharge increases. In contrast, traffic volume decreased 2% compared to 2003, primarily related to reduced automotive production at Ford and GM, partially offset by increased production at Toyota and Honda.
For 2006, automotive revenues are expected to increase modestly despite a continued decline in traffic volume. Production decreases by U.S. automotive manufacturers are expected to be partially offset by higher domestic production by foreign manufacturers. In addition to the GM plant closures that occurred in 2005, Ford announced that it will close five plants, of which NS serves the St. Louis and Atlanta assembly plants and the Batavia transmission plant.
Metals and construction revenue increased 20% and traffic volume increased 2% in 2005 compared with 2004. Revenue per unit rose 17% because of higher rates and fuel surcharges. The volume improvements were due primarily to continued strength at NS-served integrated and electric arc mills and higher aluminum product shipments, which were partially offset by lower scrap metal carloads. Construction traffic volume benefited from increased residential, commercial and highway construction.
For 2004, metals and construction revenue increased 17% and traffic volume increased 10% compared with 2003. The improvement was primarily due to increased production at NS-served integrated mills and mini-mills, the conversion of truck business to rail resulting from a shortage of flatbed trucks as well as higher scrap metal volumes resulting from expanded alliances with key scrap metal shippers and access to new scrap processors and steel mills. Construction traffic volume benefited from increased residential, commercial and highway construction.
Metals and construction volume is expected to be slightly higher in 2006, reflecting continued strength in metals and highway construction, coupled with reconstruction in the Gulf Coast region.
Chemicals revenues increased 13%, reflecting higher prices and fuel surcharges, while traffic volume was down slightly, as a result of production curtailment in the Gulf Coast region, compared with a strong 2004. Volume increases for plastic and petroleum products were offset by decreases in industrial and miscellaneous chemicals.
In 2004, chemicals revenues increased 12% and traffic volume increased 5% compared with 2003. Revenue per unit reflected higher prices in response to market conditions and fuel surcharges. The volume increase reflected manufacturers’ increased demand across all chemical business groups. Feedstocks and plastic shipments were up as inventories were restocked in anticipation of higher product prices related to increased natural gas costs, and new propane and asphalt terminals in the Southeast added carloads.
Chemical volume is expected to grow modestly in 2006, support ed by new and expanded propane and plastic plants in North Carolina and Virginia . However, volume could be adversely affected by the price of natural gas and crude oil, which accounts for more than 50% of the cost of most chemical products and presents a significant competitive challenge that could cause domestic chemical producers to move production overseas.
Agriculture, consumer products and government revenue increased 16% and traffic volume increased 2% in 2005 compared with 2004. Average revenue per unit rose 14%, a result of higher rates and fuel surcharges. Traffic volume growth resulted from sweeteners, government traffic and fertilizer. Government traffic growth was primarily due to the support of military operations in Iraq as well as shipments of temporary housing to hurricane-damaged areas. Ethanol traffic increased 38% due to higher shipments from current customers in addition to new business in Georgia and South Carolina .
In 2004, agriculture, consumer products and government revenue increased 6% and traffic volume increased 2% compared with 2003. Revenue per unit improved 3% as a result of changes in traffic mix such as increased ethanol traffic and more long haul feed shipments as well as higher prices. The volume increase was primarily driven by ethanol and fertilizer shipments. Ethanol traffic increased 59% primarily due to the opening of the Northeast market to ethanol as a gasoline additive. Fertilizer was up 7% year-over-year, reflecting higher domestic shipments to industrial customers and increased exports of phosphates, principally to China .
Agriculture, consumer products and government volume is expected to grow in 2006, benefiting from the expanding markets for ethanol and bio-diesel production and continued recovery efforts in the Gulf region.
Paper, clay and forest products revenue increased 16% and traffic volume increased 2% in 2005 compared with 2004. Average revenue per unit rose 13% due to higher rates and fuel surcharges. Pulp board, printing paper, newsprint and woodchip produced volume gains despite consolidations within the industry and mill shutdowns.
In 2004, paper, clay and forest products revenue increased 8% and traffic volume increased 1% compared with 2003, reflecting yield improvements in all segments except newsprint, together with higher printing paper, newsprint, pulp board and kaolin shipments as U.S. paper production and demand for paper products strengthened in 2004. Revenue per unit improved 6% principally as a result of price increases but also aided by higher fuel surcharges.
In 2006, paper, clay and forest product revenues are expected to benefit from paper volume, higher construction and demolition debris shipments and a new lumber distribution center that is expected to open in 2006.
INTERMODAL revenues increased $289 million, or 19% compared with 2004, reflecting improved traffic volume, higher fuel surcharges, and increased rates. Despite moderated growth in domestic business, traffic volume increased 9% reflecting strength in the international, truckload and Triple Crown Services lines of business . International traffic volume grew by 16% reflecting strength in U.S. consumer markets and growth in the movement of import and export goods through NS-served east coast ports, as well as west coast ports. Truckload volume increased 10% compared with 2004, reflecting additional business with traditional truckload companies. Premium business, which includes parcel and LTL carriers, grew 6% due primarily to new business in the Northern region. Triple Crown Services volume grew 6% reflecting expanded geographic coverage and increased trailer fleet size to meet higher demand. Domestic volume decreased 3% compared with 2004, principally due to the continued reduction in transloading of west coast international freight into domestic containers. Intermodal revenue per unit increased 9%, a result of fuel surcharges and rate increases.
In 2004, intermodal revenue increased 24% and volume increased 17% compared with 2003. Strong demand was driven by an expanding economy led by higher consumer spending, industrial production and international trade, in addition to constraints in truck and other railroads’ capacity. International steamship volume was up 15%, tied to the growth in U.S. trade volumes through east and west coast ports. Truckload volume increased 28% as a result of new business with traditional truckload companies. Premium business, which includes parcel and LTL carriers, grew 15% principally due to new parcel service between Chicago and New Jersey . Triple Crown Services Company increased volume by 8% through an expanded trailer fleet and growth in its geographic coverage. Revenue per unit improved 6%, reflecting value-based pricing and fuel surcharges.
In 2006, intermodal revenues are expected to grow as NS plans to open new terminals in Kentucky and Pennsylvania in addition to expanding existing intermodal terminals in Georgia and Ohio . In addition, strong international trade is expected to create growth opportunities in NS’ international business segment. Future growth may, however, be tempered by operating improvements at other railroads, as well as constraints in the drayage market.
Railway Operating Expenses
Railway operating expenses in 2005 were $6.4 billion, up $800 million, or 14%, compared to 2004, which were up 4% compared to 2003. The 2005 increase was principally due to a sharp rise in the price of diesel fuel, volume-related expense increases, more maintenance activities and higher casualty costs. Carloads rose 4% in 2005 compared to 2004 and 9% in 2004 compared to 2003. The increase in 2004 was largely the result of higher traffic volume, offset in part by the absence of the $107 million cost of a voluntary separation program incurred in 2003.
The railway operating ratio, which measures the percentage of railway operating revenues consumed by railway operating expenses, was 75.2% in 2005, compared with 76.7% in 2004 and 83.5% in 2003.
The following table shows the changes in railway operating expenses summarized by major classifications.
* Includes $107 million of voluntary separation costs in 2003.
Compensation and benefits , which represents about 40% of total railway operating expenses, increased $221 million, or 10%, compared with 2004 and was flat in 2004 compared with 2003. The 2005 increase reflected increased hours for train operations, including trainees, and equipment maintenance (up $70 million); increased wage rates (up $46 million); increased pension, postretirement and health and welfare benefit costs (up $43 million); higher stock-based compensation (up $22 million); and higher payroll taxes (up $12 million).
NS employment averaged 30,294 in 2005 compared with 28,475 in 2004 and 28,753 in 2003. The increased employment has come almost exclusively in operating department personnel to meet the increased volume and service needs, as well as expected retirements. NS continues to hire and train additional workers in order to meet the requirements of forecasted volumes in light of the demographics of its work force.
In 2005 and prior years, NS accounted for its stock-based compensation under APB No. 25; however, NS will adopt SFAS 123(R) in the first quarter of 2006 (see discussion under “New Accounting Pronouncement” and Note 1) which will result in higher compensation expense. The expense increase will include the effect of accelerated recognition of costs related to grants to retirement-eligible employees. Most NS salaried employees are eligible to retire at age 55 with a reduced pension benefit. SFAS No. 123(R) requires immediate expense recognition for the cost of grants made to such retirement-eligible employees rather than accrual over the expected future service period. About three-quarters of the cost of stock-based compensation granted in January 2006 will be expensed in 2006 (with almost half of the cost in the first quarter) even though some of the components are earned over a three-year period.
In 2004, compensation expenses reflected higher volume-related train and engine payroll expenses, up $39 million; higher wage rates, which added $37 million; increased stock-based compensation, up $24 million; and higher management and locomotive engineer performance-based incentive compensation, which was up $20 million. These increases were offset by lower nonagreement workforce levels, saving $24 million, as well as the absence of the $107 million expense of the 2003 voluntary separation program.
The Railroad Retirement and Survivors’ Improvement Act, which took effect Jan. 1, 2002, allows for investment of Tier II assets in a diversified portfolio through the National Railroad Retirement Investment Trust. The law also provides a mechanism for automatic adjustment of Tier II payroll taxes should the trust assets fall below a four-year reserve or exceed a six-year reserve. As a result, the employers’ portion of Tier II retirement payroll taxes have been reduced from 14.2% in 2003 to 13.1% in 2004 and to12.6% in 2005 and thereafter. However, these savings are expected to continue to be substantially offset by higher payroll taxes on increased wages and a higher wage base.
Materials, services and rents includes costs related to items used for the maintenance of railroad lines, structures and equipment; the costs of services purchased from outside contractors, including the net costs of operating joint (or leased) facilities with other railroads; and the net cost of equipment rentals. This category of expenses increased $208 million, or 13% in 2005 compared to 2004 and increased 12% in 2004 compared to 2003. The increase in 2005 reflected higher volume-related purchased services (up $82 million) and higher maintenance expense (up $74 million). Equipment rents rose $28 million, reflecting higher traffic volume as well as leases from the Conrail Corporate Reorganization (see Note 5).
The 2004 increase was the result of higher purchased services, up $100 million, including higher costs for volume-related intermodal services such as the lifting of containers and trailers and drayage. In addition, locomotive and freight car maintenance expenses rose $23 million, and equipment rents increased $33 million.
Locomotive repair costs increased in 2005 and 2004, due to more maintenance activity related to higher usage from increased traffic volumes coupled with the age of the fleet. This level of expense is expected to continue and may increase depending on traffic volumes.
Equipment rents, which includes the cost to NS of using equipment (mostly freight cars) owned by other railroads or private owners, less the rent paid to NS for the use of its equipment, rose 11% in 2005 and increased 9% in 2004. The increase in 2005 was principally due to additional lease expense for a full year from the Conrail Corporate Reorganization and increased volume-related intermodal shipments. The rise in 2004 was principally due to traffic volume (particularly intermodal shipments) and the absence of favorable settlements that benefited 2003.
Conrail rents and services decreased $190 million, or 60%, in 2005 compared to 2004 and decreased 24% in 2004 compared to 2003. This item includes amounts due to CRC for operation of the Shared Assets Areas (see Note 5). The decline in both 2005 and 2004 was primarily driven by the Conrail Corporate Reorganization, which resulted in the consolidated reporting of individual components of Conrail equity earnings, principally depreciation, equipment rents and interest expense (see Note 5). NS’ share of equity earnings after the Conrail Corporate Reorganization is a component of “Other income-net” (see Note 2).
Depreciation expense increased $176 million, or 29%, in 2005 compared to 2004 and increased 17% in 2004 compared to 2003. The increases in 2005 and 2004 were primarily a result of the Conrail Corporate Reorganization (see Note 5). In addition, substantial capital investments and improvements affected all years, resulting in higher depreciation expense.
In 2004, NS received the results of a roadway depreciation study from an independent firm of engineers. The results of the study, which were implemented in September 2004, prospectively reduced depreciation expense by approximately $17 million annually. In 2006, NS expects to complete an equipment depreciation study and an analysis of the assets received in the Conrail Corporate Reorganization. The results of these items are expected to reduce depreciation expense, making 2006 comparable with 2005.
Diesel fuel expenses increased 62% in 2005 compared with 2004 and increased 18% in 2004 compared with 2003. Diesel fuel expense is recorded net of hedge benefits (see “Market Risks and Hedging Activities,” below and Note 16). The increase in 2005 reflects a 43% rise in the average price per gallon and a 2% increase in consumption. The increase in 2004 reflects a 13% rise in the average price per gallon and a 6% increase in consumption. Expenses in 2005 included hedge benefits of $148 million compared with benefits of $140 million in 2004 and $59 million in 2003. NS has hedged approximately 4% of expected 2006 diesel fuel requirements as of Dec. 31, 2005 , at an average price of 89 cents per gallon. No new hedges have been entered into since May 2004. Accordingly, if diesel fuel prices remain at their current levels, or increase further, diesel fuel expense will be higher in 2006.
Legislation enacted in the first quarter of 2005 repeals the 4.3 cents per gallon excise tax on railroad diesel fuel and inland waterway fuel by 2007, with the following phased reductions in 2005 and 2006: by 1 cent per gallon from Jan. 1, 2005 through June 30, 2005; 2 cents per gallon from July 1, 2005 through Dec. 31, 2006; and by the full 4.3 cents thereafter. NS consumes over 500 million gallons of diesel fuel per year.
Casualties and other claims expenses (including the estimates of costs related to personal injury, property damage and environmental matters) increased 48% in 2005 compared to 2004 and decreased 17% in 2004 compared to 2003. The increase in 2005 reflected costs associated with a derailment in Graniteville , South Carolina (see discussion below), $16 million for an unfavorable jury verdict received in an FELA case, $9 million of higher insurance costs, and $4 million for the portion of the $12.5 million self-insured retention related to Hurricane Katrina expenses. The decline in 2004 reflected favorable personal injury and freight claims development and higher insurance settlements, partially offset by increased derailment expenses.
On Jan. 6, 2005 , a collision in Graniteville , South Carolina , between two NS trains caused the release of chlorine gas from a ruptured tank car. NS’ liability in 2005 related to this accident includes a current and long-term portion which represents NS’ best estimate based on current facts and circumstances. The estimate includes amounts related to business property damage and other economic losses, personal injury and individual property damage claims as well as third-party response costs. NS’ commercial insurance policies are expected to cover substantially all expenses related to this derailment above NS’ self-insured retention, including NS’ response costs and legal fees. Accordingly, the Consolidated Balance Sheet reflects a current and long-term receivable for estimated recoveries from NS’ insurance carriers. The $41 million expense recorded in 2005 represents NS’ retention under its insurance policies and other uninsured costs. While it is reasonable to expect that the liability for covered losses could differ from the amount recorded, such a change would be offset by a corresponding change in the insurance receivable. As a result, NS does not believe that it is reasonably likely that its net loss (the difference between the liability and future recoveries) will be materially different than the loss recorded in 2005. NS expects at this time that insurance coverage is adequate to cover potential claims and settlements above its self-insurance retention.
During the third quarter, NS’ operations were adversely affected by Hurricane Katrina, and to a lesser extent, Hurricane Rita, both of which struck the Gulf Coast . NS sustained damage to its facilities in the region as a result of Hurricane Katrina but restored rail freight service into and around New Orleans in a relatively short period of time. The damage sustained to NS facilities as a result of Hurricane Katrina did not materially impact NS’ financial condition or results of operations and is covered by insurance above the self-insurance retention limit.
The largest component of casualties and other claims expense is personal injury costs. Cases involving occupational injuries comprised about one-third of total employee injury cases resolved and about one-fourth of total payments made. With its long-established commitment to safety, NS continues to work actively to eliminate all employee injuries and to reduce the associated costs. With respect to occupational injuries, which are not caused by a specific accident or event, but result from a claimed exposure over time, the benefits of any existing safety initiatives may not be realized immediately. These types of claims are being asserted by former or retired employees, some of whom have not been actively employed in the rail industry for decades.
The rail industry remains uniquely susceptible to litigation involving job-related accidental injury and occupational claims because of the Federal Employers' Liability Act (FELA), which is applicable only to railroads. FELA’s fault-based system, which covers employee claims for job-related injuries, produces results that are unpredictable and inconsistent as compared with a no-fault workers' compensation system.
NS maintains substantial amounts of commercial insurance for potential third-party liability and property damage claims. It also retains reasonable levels of risk through self-insurance (see Note 18). NS expects insurance costs to be higher in 2006.
Other expenses increased 15% in 2005 compared to 2004 and 5% in 2004 compared to 2003. Both 2005 and 2004 reflected higher property and sales and use taxes.
Other income – net was $74 million in 2005 and $89 million in 2004, which included the $53 million gain from the Conrail Corporate Reorganization (see Note 5). Results in 2005 reflected: (1) higher interest income (up $28 million), (2) equity in earnings of Conrail subsequent to the Conrail Corporate Reorganization (up $26 million), (3) additional coal royalties (up $12 million), and (4) lower interest accruals related to tax liabilities (down $9 million). These income improvements were partially offset by more expense associated with tax credit investments (up $39 million).
In 2004, other income – net increased by $70 million, reflecting the absence of the $84 million telecommunications assets impairment charge that burdened 2003 (see Note 6) and the gain in 2004 on the Conrail Corporate Reorganization (see Note 5). These increases combined to more than offset expenses from an investment in a limited liability company that owns and operates facilities that produce synthetic fuel from coal (see Note 2). The production of synthetic fuel results in tax credits as well as expenses related to the investments. The expenses are recorded as a component of “Other income – net,” and the tax credits, as well as tax benefits related to the expenses, are reflected in the provision for income taxes (see Note 3).
Income tax expense in 2005 was $416 million for an effective rate of 25%, compared with effective rates of 29% in 2004 and 30% in 2003. The large decline in 2005 resulted from the Ohio tax legislation changes, which lowered deferred taxes by $96 million and the effective tax rate by six percentage points (see Note 3).
As shown in Note 3 to the Consolidated Financial Statements, which sets forth a reconciliation from the statutory rate to the effective rate for all three years, the effective rates in both 2005 and 2004 were reduced as a result of tax credits from synthetic fuel-related investments. In addition, 2004 benefited from the favorable resolution of an IRS audit of a synthetic fuel related investment. The effective rates in all three years benefited from favorable adjustments upon filing the prior year tax returns and favorable adjustments to state tax liabilities.
The consolidated federal income tax returns for 2002 through 2003 are being audited by the Internal Revenue Service (IRS). The IRS completed its examination of the 2000 and 2001 consolidated federal income tax returns and issued a Revenue Agent’s Report in September 2005, which had a negligible effect on the effective tax rate.
For the 2001 through 2004 tax years , 30% and 50% bonus depreciation was allowed for federal income tax purposes. Except for certain areas affected by Hurricane Katrina, bonus depreciation was not available in 2005. In addition, the Conrail Corporate Reorganization resulted in NS receiving assets with less future tax depreciation than book depreciation. As a result, current taxes were higher in 2005 than in earlier years and are expected to remain higher in 2006 .
NS’ interests in synthetic fuel credits are subject to reduction if the Reference Price of a barrel of oil for the year falls within an inflation-adjusted phase-out range specified by the tax code. The Reference Price for a year is the annual average wellhead price per barrel of unregulated domestic crude oil as determined by the Secretary of the Treasury by April 1 of the following year. In 2004, the phase-out range was $51.35 to $64.47. The phase-out range for 2005 and later years will be adjusted for inflation. No phase out is considered likely in 2005; however, NS cannot predict with certainty the Reference Price of a barrel of oil for later years. If the Reference Price for a year falls within or exceeds the applicable phase-out range for that year, NS’ synthetic fuel credits could be reduced or eliminated. However, indemnification arrangements limit NS’ exposure if tax credits are reduced due to oil prices.
In 2003, income from discontinued operations consisted of a $10 million after-tax gain related to the resolution of tax issues arising from the sale of NS’ motor carrier subsidiary (see Note 17).
FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES
Cash provided by operating activities, NS' principal source of liquidity, was $2.1 billion in 2005, compared with $1.7 billion in 2004 and $1.1 billion in 2003. The improvement in 2005 reflected the $415 million increase in income from railway operations as well as the effects of the Conrail Corporate Reorganization (see below), offset in part by higher income tax payments, including a payment made upon settlement of a federal audit cycle. In 2004, the increase was primarily due to increased railway operating income.
Prior to the Conrail Corporate Reorganization (see Note 5), a significant portion of the payments made to PRR under the operating and lease agreements (which were included in “Conrail rents and services” and, therefore, were a use of cash in “Cash provided by operating activities”), was borrowed back from a subsidiary of PRR under a note due in 2032, and therefore, was a source of cash in “Proceeds from borrowings.” NS’ net cash flow from these borrowings amounted to $118 million in 2004 and $203 million in 2003. This note was effectively extinguished by the reorganization in 2004. Subsequent to the Conrail Corporate Reorganization, payments under “Conrail rents and services” have declined, depreciation charges have increased and the net borrowings have been terminated. Accordingly, NS’ cash provided by operating activities after the Conrail Corporate Reorganization has increased.
NS had working capital of $729 million at Dec. 31, 2005 , compared with a working capital deficit of $234 million at Dec. 31, 2004 . The improvement reflected higher cash provided by operating activities, as well as a $348 million reduction in current maturities of long-term debt. NS expects that cash on hand combined with cash flow from operations will be sufficient to meet its ongoing obligations. This expectation is based on a view that the economy will continue at a moderate growth rate through 2006.
Contractual obligations at Dec. 31, 2005, related to NS' long-term debt (including capital leases) (see Note 8), operating leases (see Note 9), agreements with CRC (see Note 5), unconditional purchase obligations (see Note 18) and other long-term obligations (see Note 18), are as follows:
Off balance sheet arrangements consist of operating lease obligations, which are included in the table of contractual obligations above and disclosed in Note 9. NS did not renew its accounts receivable securitization program which expired in May 2005.
Cash used for investing activities was $1.8 billion in 2005, compared with $1.2 billion in 2004 and $640 million in 2003. The increase in 2005 was principally the result of larger purchases of short-term investments, while the rise in 2004 resulted from higher property additions and the investment in a membership interest in a limited liability company that owns and operates facilities that produce synthetic fuel from coal. Property additions account for most of the recurring spending in this category. The following tables show capital spending (including capital leases) and track and equipment statistics for the past five years.
Capital expenditures in 2005 were $16 million, or 2%, lower than 2004 principally due to decreases in equipment purchases that were partially offset by increased investment in roadway projects. In 2004, h igher capital expenditures were primarily due to increased locomotive purchases as well as investment in roadway projects, Triple Crown Services equipment and freight cars.
Through its coal car rebody program, which was suspended in 2000, NS converted about 29,000 hopper cars into high-capacity steel gondolas or hoppers. As a result, the remaining service life of the freight-car fleet is greater than may be inferred from the increasing average age shown in the table above.
For 2006, NS has budgeted $1.15 billion for capital expenditures. The anticipated spending includes $735 million for roadway projects, of which $484 million is for track and bridge program work. Also included are projects for communications, signal and electrical systems, as well as projects for environmental and public improvements such as grade crossing separations and signal upgrades. Other roadway projects include marketing and industrial development initiatives, including increasing track capacity and access to coal receivers and vehicle production and distribution facilities, and continuing investments in intermodal infrastructure. Equipment spending of $358 million includes the purchase of 133 locomotives and upgrades to existing units, improvements to multilevel automobile racks, and projects related to computers and information technology, including additional security and backup systems. NS expects to make all of its capital expenditures with internally generated funds.
On Dec. 2, 2005 , NS announced an agreement to form a joint venture with Kansas City Southern pursuant to which NS intends to contribute $300 million in cash, substantially all of which will be used for capital improvements over a period of approximately four years, in exchange for a 30% interest in the joint venture. Kansas City Southern will contribute a 320 mile rail line between Meridian , Mississippi and Shreveport , Louisiana (the “Meridian Speedway”). Closing of the transaction is conditioned on the receipt of the necessary authority from the Surface Transportation Board. Accordingly, if the transaction is authorized and consummated, NS expects to recognize its pro rata share of the joint venture’s earnings or loss as required under the equity method of accounting. The transaction is expected to be modestly dilutive in the early years of the venture due to lost interest income on the cash contributed to the joint venture. However, NS expects that the dilution from the lost interest income will be offset from additional traffic as the investment is made and improvements are completed. The joint venture is expected to increase capacity and improve service on the Meridian Speedway.
NS expects to spend $50 million, in the near future, connected with Heartland Corridor-related projects. The Heartland Corridor is a package of proposed clearance improvements and other facilities that will create a seamless high-capacity intermodal route across Virginia and West Virginia to Midwest markets. Completion of the related projects is contingent on securing public or third-party funding commitments.
NS and other railroads have agreed to participate in the Chicago Region Environmental and Transportation Efficiency (CREATE) project in Chicago . The intent of the proposed public-private partnership is to reduce rail and highway congestion and add freight and passenger capacity in the metropolitan Chicago area. A portion of the public funding has been approved and the parties are working to develop a list of projects to be included in Phase I of the project. Funding requirements will be determined by the selection of Phase I projects. The railroads expect to complete Phase I over the next four years.
Cash used for financing activities was $456 million in 2005, compared with $233 million in 2004 and $314 million in 2003. Financing activity in 2005 included: (1) the issuance of $300 million aggregate principal amount of 6% unsecured notes due March 2105, and (2) the issuance of $717 million of unsecured notes ($350 million at 5.64% due 2029 and $367 million at 5.59% due 2025) and payment of $218 million of premium in exchange for $717 million of previously issued unsecured notes ($350 million at 7.8% due 2027, $200 million at 7.25% due 2031, and $167 million at 9.0% due 2021) (see Note 8). The $218 million cash premium payment is reflected as a reduction of debt in the Consolidated Balance Sheets and Statement of Cash Flows and will be amortized as additional interest expense over the terms of the new debt. Investing activities in 2005 and 2004 also included substantial proceeds from employee exercise of stock options. NS’ debt-to-total capitalization ratio was 42.7% at Dec. 31, 2005 , and 48.5% at Dec. 31, 2004 .
In November 2005, NS’ Board of Directors authorized the repurchase of up to 50 million shares of NS Common Stock through the end of 2015. The timing and volume of any purchases will be guided by management’s assessment of market conditions and other pertinent factors. Near-term purchases under the program are expected to be made with internally generated cash; however, future funding sources could include proceeds from the sale of commercial paper notes or the issuance of long-term debt.
NS currently has in place and available a $1 billion, five-year credit agreement, which provides for borrowings at prevailing rates and includes financial covenants. There were no amounts outstanding under this facility at Dec. 31, 2005 , and NS is in compliance with all of the financial covenants. NS also has in place a shelf registration statement on Form S-3 filed with the SEC in September 2004 with $700 million of available capacity (see Note 8). On July 18, 2005 , Standard & Poor’s (S&P) upgraded its ratings on NS’ unsecured debt from BBB to BBB+. Moody’s rating remains at Baa1, comparable to S&P’s.
APPLICATION OF CRITICAL ACCOUNTING ESTIMATES
The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions may require significant judgment about matters that are inherently uncertain, and future events are likely to occur that may require management to change them. Accordingly, management regularly reviews these estimates and assumptions based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances. Management discusses the development, selection and disclosures concerning critical accounting estimates with the Audit Committee of its Board of Directors.
Pensions and Other Postretirement Benefits
Accounting for pensions and other postretirement benefit plans requires management to make several estimates and assumptions (see Note 11). These include the expected rate of return from investment of the plans' assets, projected increases in medical costs and the expected retirement age of employees as well as their projected earnings and mortality. In addition, the amounts recorded are affected by changes in the interest rate environment because the associated liabilities are discounted to their present value. Management makes these estimates based on the company's historical experience and other information that it deems pertinent under the circumstances (for example, expectations of future stock market performance). Management engages an independent consulting actuarial firm to assist it in selecting appropriate assumptions and valuing its related liabilities.
NS' net pension benefit, which is included in “Compensation and benefits” on its Consolidated Income Statement, was $23 million for the year ended Dec. 31, 2005 . In recording this amount, NS assumed a long-term investment rate of return of 9%. Investment experience of the pension fund over the past 10-, 15- and 20-year periods has been a rate of return in excess of 10%. A one percentage point change to this rate of return assumption would result in an $18 million change to the pension credit and, as a result, an equal change in “Compensation and benefits” expense. Changes that are reasonably likely to occur in assumptions concerning retirement age, projected earnings and mortality would not be expected to have a material effect on NS' net pension benefit or net pension asset in the future. The net pension asset is recorded at its net present value using a discount rate that is based on the current interest rate environment in light of the timing of expected benefit payments. Specifically, NS refers to Moody’s seasoned Aa corporate bond yields and the changes in such yields; therefore, management has little discretion in this assumption.
NS' net cost for other postretirement benefits, which is also included in “Compensation and benefits,” was $62 million for the year ended Dec. 31, 2005 . In recording this expense and valuing the net liability for other postretirement benefits, which is included in “Other benefits” as disclosed in Note 11, management estimated future increases in health-care costs. These assumptions, along with the effect of a one percentage point change in them, are described in Note 11.
Properties and Depreciation
Most of NS' total assets are comprised of long-lived railway properties (see Note 6). As disclosed in Note 1, NS' properties are depreciated using group depreciation. Rail is depreciated primarily on the basis of use measured by gross-ton miles. Other properties are depreciated generally using the straight-line method over the lesser of estimated service or lease lives. NS reviews the carrying amount of properties whenever events or changes in circumstances indicate that such carrying amount may not be recoverable based on future undiscounted cash flows. Assets that are deemed impaired as a result of such review are recorded at the lesser of carrying amount or fair value.
NS' depreciation expense is based on management's assumptions concerning service lives of its properties as well as the expected net salvage that will be received upon their retirement. These assumptions are the product of periodic depreciation studies that are performed by a firm of consulting engineers. These studies analyze NS' historical patterns of asset use and retirement and take into account any expected change in operation or maintenance practices. NS' recent experience with these studies has been that while they do result in changes in the rates used to depreciate its properties, these changes have not caused a significant effect to its annual depreciation expense. The studies may also indicate that the recorded amount of accumulated depreciation is deficient (or in excess) of the amount indicated by the study. Any such deficiency (or excess) is amortized as a component of depreciation expense over the remaining service lives of the affected class of property. NS' “Depreciation expense” for the year ended Dec. 31, 2005 , amounted to $774 million. NS' weighted-average depreciation rates for 2005 are disclosed in Note 6; a one-tenth percentage point increase (or decrease) in these rates would have resulted in a $25 million increase (or decrease) to NS' depreciation expense.
Personal Injury, Environmental and Legal Liabilities
NS' expense for “Casualties and other claims” amounted to $224 million for the year ended Dec. 31, 2005 . Most of this expense was composed of NS' accrual related to personal injury liabilities (see discussion of FELA in the discussion captioned “Casualties and other claims” above). Job-related personal injury and occupational claims are subject to FELA, which is applicable only to railroads. FELA’s fault-based tort system produces results that are unpredictable and inconsistent as compared with a no-fault worker’s compensation system. The variability inherent in this system could result in actual costs being very different from the liability recorded. In all cases, NS records a liability when the expected loss for the claim is both probable and estimable.
NS engages an independent consulting actuarial firm to aid in valuing its personal injury liability and determining the amount to accrue during the year. For employee personal injury cases, the actuarial firm studies NS' historical patterns of reserving for claims and subsequent settlements, taking into account relevant outside influences. An estimate of the ultimate amount of the liability, which includes amounts for incurred but unasserted claims, is based on the results of this analysis. For occupational injury claims, the actuarial firm studies NS’ history of claim filings, severity, payments and other relevant facts. Additionally, the estimate of the ultimate loss for occupational injuries includes a provision for those claims that have been incurred but not reported by projecting NS’ experience into the future as far as can be reasonably determined. NS has recorded this actuarially determined liability. The liability is dependent upon many individual judgments made as to the specific case reserves as well as the judgments of the consulting actuary and management in the periodic studies. Accordingly, there could be significant changes in the liability, which NS would recognize when such a change became known. The most recent actuarial study, completed in the fourth quarter of 2005, resulted in a slight decrease to NS' personal injury liability during the fourth quarter. While the liability recorded is support ed by the most recent study, it is reasonably possible that the liability could be higher or lower.
NS is subject to various jurisdictions' environmental laws and regulations. It is NS' policy to record a liability where such liability or loss is probable and its amount can be estimated reasonably (see Note 18). Environmental engineers regularly participate in ongoing evaluations of all known sites and in determining any necessary adjustments to liability estimates. NS also has established an Environmental Policy Council, composed of senior managers, to oversee and interpret its environmental policy.
Operating expenses for environmental matters totaled approximately $16 million in 2005, $11 million in 2004 and $9 million in 2003, and capital expenditures totaled approximately $9 million in each of 2005, 2004 and 2003. Capital expenditures in 2006 are expected to be comparable to those in 2005.
NS' balance sheets included liabilities for environmental exposures in the amount of $58 million at Dec. 31, 2005 , and $64 million at Dec. 31, 2004 (of which $12 million was accounted for as a current liability at Dec. 31, 2005 , and 2004). At Dec. 31, 2005 , the liability represented NS' estimate of the probable cleanup and remediation costs based on available information at 189 identified locations. On that date, 16 sites accounted for $30 million of the liability, and no individual site was considered to be material. NS anticipates that much of this liability will be paid out over five years; however, some costs will be paid out over a longer period.
At some of the 189 locations, certain NS subsidiaries, usually in conjunction with a number of other parties, have been identified as potentially responsible parties by the Environmental Protection Agency (EPA) or similar state authorities under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, or comparable state statutes, which often impose joint and several liability for cleanup costs.
With respect to known environmental sites (whether identified by NS or by the EPA or comparable state authorities), estimates of NS' ultimate potential financial exposure for a given site or in the aggregate for all such sites are necessarily imprecise because of the widely varying costs of currently available cleanup techniques, the likely development of new cleanup technologies, the difficulty of determining in advance the nature and full extent of contamination and each potential participant's share of any estimated loss (and that participant's ability to bear it), and evolving statutory and regulatory standards governing liability. NS estimates its environmental remediation liability on a site-by-site basis, using assumptions and judgments that management deems appropriate for each site. As a result, it is not practical to quantitatively describe the effects of changes in these many assumptions and judgments. NS has consistently applied its methodology of estimating its environmental liabilities.
Based on its assessment of the facts and circumstances now known, management believes that it has recorded the probable costs for dealing with those environmental matters of which the Corporation is aware. Further, management believes that it is unlikely that any known matters, either individually or in the aggregate, will have a material adverse effect on NS' financial position, results of operations or liquidity.
Norfolk Southern and certain subsidiaries are defendants in numerous lawsuits and other claims relating principally to railroad operations. When management concludes that it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, it is accrued through a charge to expenses. While the ultimate amount of liability incurred in any of these lawsuits and claims is dependent on future developments, in management's opinion the recorded liability, if any, is adequate to cover the future payment of such liability and claims. However, the final outcome of any of these lawsuits and claims cannot be predicted with certainty, and unfavorable or unexpected outcomes could result in additional accruals that could be significant to results of operations in a particular year or quarter. Any adjustments to recorded liabilities will be reflected in expenses in the periods in which such adjustments are known.
NS' net long-term deferred tax liability totaled $6,620 million at Dec. 31, 2005 (see Note 3). This liability is estimated based on the expected future tax consequences of items recognized in the financial statements. After application of the federal statutory tax rate to book income, judgment is required with respect to the timing and deductibility of expenses in the corporate income tax returns . For state income and other taxes, judgment is also required with respect to the apportionment among the various jurisdictions. A valuation allowance is recorded if management expects that it is more likely than not that its deferred tax assets will not be realized. NS had a $16 million valuation allowance on $775 million of deferred tax assets as of Dec. 31, 2005 , reflecting the expectation that most of these assets will be realized. In addition, NS has a recorded liability for its estimate of potential income tax exposures. Management believes this liability for potential exposure to be adequate. Income tax expense is adjusted to the extent the final outcome of these matters differs from the amounts recorded. For every one half percent change in the 2005 effective rate net income would have changed by $8 million.
Approximately 26,000, or about 85%, of NS' railroad employees are covered by collective bargaining agreements with various labor unions. These agreements remain in effect until changed pursuant to the Railway Labor Act (RLA). NS largely bargains in concert with other major railroads. Moratorium provisions in the labor agreements govern when the railroads and the unions may propose labor agreement changes. The previous moratorium provisions expired in the latter part of 2004 and the railroads and the rail labor unions thereafter served new proposals to begin the next bargaining round. Industry issues include train crew staffing and employee contributions for health care benefits.
Seven rail unions (Brotherhood of Locomotive Engineers and Trainmen, Brotherhood of Maintenance of Way Employes, American Train Dispatchers Association, Brotherhood of Railroad Signalmen, International Brotherhood of Blacksmiths and Boilermakers, National Conference of Firemen and Oilers, and Sheet Metal Workers International Association) are bargaining together under the auspices of the Rail Labor Bargaining Coalition (RLBC). The railroads filed for mediation with the United Transportation Union (UTU) and with the RLBC unions. The status quo is preserved during mediation while a federal mediator assists the parties in their efforts to reach agreement. If the NMB were to terminate mediation, it would, at that time, propose that the parties arbitrate their differences. A strike could occur 30 days thereafter if the parties did not accept arbitration. However, the President of the United States of America could then appoint an Emergency Board which would delay any strike for a further 60 days while the Board made recommendations and the parties and engaged in further negotiations. The outcome of the negotiations cannot be determined at this point.
Market Risks and Hedging Activities
NS has used derivative financial instruments to reduce the risk of volatility in its diesel fuel costs and to manage its overall exposure to fluctuations in interest rates.
In 2001, NS began a program to hedge a portion of its diesel fuel consumption. The intent of the program is to assist in the management of NS' aggregate risk exposure to fuel price fluctuations, which can significantly affect NS' operating margins and profitability, through the use of one or more types of derivative instruments.
Diesel fuel costs represented 11% of NS' operating expenses for 2005. The program provides that NS will not enter into any fuel hedges with a duration of more than 36 months, and that no more than 80% of NS' average monthly fuel consumption will be hedged for any month within any 36-month period.
As of Dec. 31, 2005 , through swap transactions, NS has hedged approximately 4% of expected 2006 diesel fuel requirements. The effect of these hedges is to yield an average cost of 89 cents per hedged gallon, including federal taxes and transportation. A 10% decrease in diesel fuel prices would reduce NS' asset related to the swaps by approximately $4 million as of Dec. 31, 2005 .
However, with fuel prices near historic highs and fuel surcharges being collected under certain tariffs and contracts, NS has not entered into additional hedges since May 2004. Consequently, the past pattern of entering into regular monthly swaps may not be indicative of future hedging activity. If diesel fuel prices remain at their current levels, or increase further, diesel fuel expense will be higher going forward.
NS manages its overall exposure to fluctuations in interest rates by issuing both fixed- and floating-rate debt instruments and by entering into interest-rate hedging transactions to achieve an appropriate mix within its debt portfolio.
At Dec. 31, 2005 , NS' debt subject to interest rate fluctuations totaled $285 million. A 1% increase in interest rates would increase NS' total annual interest expense related to all its variable debt by approximately $3 million. Management considers it unlikely that interest rate fluctuations applicable to these instruments will result in a material adverse effect on NS' financial position, results of operations or liquidity.
Some of NS' capital leases, which carry an average fixed rate of 7%, were effectively converted to variable rate obligations using interest rate swap agreements. On Dec. 31, 2005 , the average pay rate under these agreements was 7%, and the average receive rate was 5%. During 2005, the effect of the swaps was to reduce interest expense by $2 million. A portion of the lease obligations is payable in Japanese yen. NS eliminated the associated exchange rate risk at the inception of each lease with a yen deposit sufficient to fund the yen-denominated obligation. Most of these deposits are held by foreign banks, primarily Japanese. As a result, NS is exposed to financial market risk relative to Japan . Counterparties to the interest rate swaps and Japanese banks holding yen deposits are major financial institutions believed by management to be creditworthy.
New Accounting Pronouncement
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R), “Share-Based Payments”. This statement establishes standards for accounting for transactions in which an entity exchanges its equity instruments for goods or services, such as stock-based compensation plans. NS will adopt this standard in the first quarter of 2006, which will result in higher compensation expense (see Note 1). The statement applies to all awards granted after the effective date and to awards modified, repurchased, or cancelled after that date, as well as awards that are unvested at the effective date.
In preparing financial statements, U.S. generally accepted accounting principles require the use of historical cost that disregards the effects of inflation on the replacement cost of property. NS, a capital-intensive company, has most of its capital invested in such assets. The replacement cost of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical cost.
This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that may be identified by the use of words like “believe,” “expect,” “anticipate” and “project.” Forward-looking statements reflect management's good-faith evaluation of information currently available. However, such statements are dependent on and, therefore, can be influenced by, a number of external variables over which management has little or no control, including: legislative and regulatory developments; competition and consolidation within the transportation industry; domestic and international economic conditions; the business environment in industries that produce and consume rail freight; the operations of carriers with which we interchange; labor difficulties, including strikes and work stoppages; disruptions to our technology infrastructure including our computer systems; natural events such as severe weather, floods and hurricanes; acts of terrorism or war; fluctuation in prices of key materials, in particular diesel fuel; and changes in securities and capital markets. Forward-looking statements are not, and should not be relied upon as, a guaranty of future performance or results. Nor will they necessarily prove to be accurate indications of the times at or by which any such performance or results will be achieved. As a result, actual outcomes and results may differ materially from those expressed in forward-looking statements. NS undertakes no obligation to update or revise forward-looking statements.
Item 7A . Quantitative and Qualitative Disclosures about Market Risk.
The information required by this item is included in Part II, Item 7, “Management's Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Market Risks and Hedging Activities.”
Item 8 . Financial Statements and Supplementary Data.
Report of Management
February 21, 2006
To the Stockholders
Norfolk Southern Corporation
Management is responsible for establishing and maintaining adequate internal control over financial reporting. In order to ensure that the Corporation's internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2005. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management has concluded that the Corporation maintained effective internal control over financial reporting as of December 31, 2005 .
KPMG LLP, independent registered public accounting firm, has audited the Corporation's financial statements and has reported on management's assessment of the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2005 .
Report of Independent Registered Public Accounting Firm
The Stockholders and Board of Directors
Norfolk Southern Corporation:
We have audited management's assessment, included in the accompanying Report of Management, that Norfolk Southern Corporation maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Norfolk Southern Corporation's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management's assessment and an opinion on the effectiveness of Norfolk Southern Corporation’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board ( United States ). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with U.S. generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with U.S. generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assessment that Norfolk Southern Corporation maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Norfolk Southern Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control—Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
Report of Independent Registered Public Accounting Firm
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Norfolk Southern Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2005. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in Item 15(A)2. Our report dated February 21, 2006 , expressed an unqualified opinion on the consolidated financial statements and financial statement schedule.
/s/ KPMG LLP
Norfolk , Virginia
February 21, 2006
Report of Independent Registered Public Accounting Firm
The Stockholders and Board of Directors
Norfolk Southern Corporation:
We have audited the accompanying consolidated balance sheets of Norfolk Southern Corporation and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2005 . In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in Item 15(A)2. These consolidated financial statements and financial statement schedule are the responsibility of Norfolk Southern Corporation’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board ( United States ). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence support ing the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We 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 position of Norfolk Southern Corporation and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles. Also in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
As discussed in note 1 to the consolidated financial statements, effective January 1, 2003 , Norfolk Southern Corporation adopted Financial Accounting Standards Board Statement No. 143, Accounting for Asset Retirement Obligations, and Financial Accounting Standards Board Interpretation No. 46, Consolidation of Variable Interest Entities.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Norfolk Southern Corporation’s internal control over financial reporting as of December 31, 2005, 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 21, 2006, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ KPMG LLP
Norfolk , Virginia
February 21, 2006
Norfolk Southern Corporation and Subsidiaries
Consolidated Statements of Income
Norfolk Southern Corporation and Subsidiaries
Consolidated Balance Sheets
Norfolk Southern Corporation and Subsidiaries
Consolidated Statements of Cash Flows
Norfolk Southern Corporation and Subsidiaries
Consolidated Statements of Changes in Stockholders' Equity