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| NSC > SEC Filings for NSC > Form 10-Q on 24-Oct-2008 | All Recent SEC Filings |
24-Oct-2008
Quarterly Report
Management's Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
Third-quarter 2008 net income was up $134 million, or 35%, compared with the same period last year. The improvement primarily resulted from a $213 million increase in income from railway operations, reflecting higher average revenue per unit (including fuel surcharges) that continued to more than offset the effects of lower traffic volume and increased operating expenses. The railway operating ratio (a measure of the amount of operating revenues consumed by operating expenses) decreased to 69.1% in the third quarter from 71.1% in the prior year.
Cash provided by operating activities for the first nine months was $2.1 billion which provided funding for capital expenditures, dividends, and, supplemented with proceeds from borrowings, share repurchases. In the third quarter of 2008, 6.2 million shares of Norfolk Southern Corporation common stock (Common Stock) were repurchased at a total cost of $405 million. Since inception of the share repurchase program in 2006, NS has repurchased and retired 60.5 million shares of Common Stock at a total cost of $3.1 billion. At Sept. 30, 2008, cash and short-term investment balances totaled $557 million.
SUMMARIZED RESULTS OF OPERATIONS
Third-quarter 2008 net income was $520 million, up $134 million, or 35%, compared with the same period last year. The improvement primarily resulted from a $213 million increase in income from railway operations that reflected a $541 million, or 23%, rise in railway operating revenues coupled with a $328 million, or 20%, increase in railway operating expenses. Third-quarter net income was reduced by an $83 million increase in income taxes, reflecting both higher pretax income and the absence of benefits associated with synthetic fuel tax credits that expired in 2007.
For the first nine months of 2008, net income was $1.3 billion, up $199 million, or 19%, compared with the same period last year. Increases of $372 million in income from railway operations and $33 million in other income were offset in part by a $207 million increase in income taxes. Railway operating revenues rose $1.2 billion, or 17%, while railway operating expenses were up $809 million, or 16%.
As a commodity, oil prices impact NS' results of operations in a variety of ways
and can have an overall favorable or unfavorable impact in any particular
quarter. In addition to the impact of oil prices on general economic
conditions and traffic volume, oil prices directly affect NS' revenues through
market-based fuel surcharges and contract escalators (see "Railway Operating
Revenues") and expenses through fuel expense (see "Railway Operating Expenses").
For the third quarter and first nine months, oil prices had an overall
favorable impact on income from railway operations. Future changes in oil
prices may cause volatility in operating results that could be material to a
particular quarter or year.
DETAILED RESULTS OF OPERATIONS
Railway Operating Revenues
Third-quarter 2008 railway operating revenues were $2.9 billion, up $541 million, or 23%, compared with the third quarter of 2007. As shown in the following table, the increases were the result of higher average revenue per unit, including increased fuel surcharges, which were offset in part by lower traffic volume. Fuel surcharges amounted to $535 million in the third quarter (up $339 million) and $1.3 billion for the first nine months (up $714 million).
Many of Norfolk Southern's negotiated fuel surcharges for coal and general merchandise traffic are based on the monthly average price of West Texas Intermediate Crude Oil (WTI Average Price). These surcharges are reset the first day of each calendar month based on the WTI Average Price for the second preceding calendar month. This two-month lag in computing WTI Average Price increased fuel surcharge revenue by approximately $55 million for the third quarter, but decreased fuel surcharge revenue by approximately $39 million for the first nine months.
Third Quarter First Nine Months
2008 vs. 2007 2008 vs. 2007
Increase (Decrease) Increase (Decrease)
($ in millions)
Revenue per unit/mix $558 $1,301
Traffic volume (units) (17) (120)
Total $541 $1,181
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Revenues, units and average revenue per unit for NS' market groups were as follows:
Third Quarter
Revenues Units Revenue per Unit
2008 2007 2008 2007 2008 2007
($ in millions) (in thousands) ($ per unit)
Coal $ 876 $ 578 450.9 427.3 $ 1,941 $ 1,353
General merchandise:
Chemicals 337 297 103.0 108.0 3,275 2,748
Metals/construction 357 287 203.7 200.3 1,752 1,433
Agr./consumer prod./govt. 338 264 158.6 151.4 2,136 1,747
Automotive 185 221 86.7 123.5 2,125 1,784
Paper/clay/forest 241 222 101.5 108.5 2,376 2,045
General merchandise 1,458 1,291 653.5 691.7 2,232 1,866
Intermodal 560 484 790.9 790.1 708 612
Total $ 2,894 $ 2,353 1,895.3 1,909.1 $ 1,527 $ 1,232
First Nine Months
Revenues Units Revenue per Unit
2008 2007 2008 2007 2008 2007
($ in millions) (in thousands) ($ per unit)
Coal $ 2,313 $ 1,714 1,326.2 1,282.1 $ 1,744 $ 1,337
General merchandise:
Chemicals 964 868 309.1 323.4 3,119 2,683
Metals/construction 1,014 860 600.6 595.7 1,689 1,444
Agr./consumer prod./govt. 963 759 467.3 447.0 2,062 1,698
Automotive 640 703 322.6 402.9 1,983 1,744
Paper/clay/forest 687 649 304.1 326.8 2,259 1,987
General merchandise 4,268 3,839 2,003.7 2,095.8 2,130 1,832
Intermodal 1,578 1,425 2,294.4 2,345.0 688 607
Total $ 8,159 $ 6,978 5,624.3 5,722.9 $ 1,451 $ 1,219
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Coal
Coal revenues increased $298 million, or 52%, in the third quarter and
$599 million, or 35%, in the first nine months, compared with the same periods
last year. Both increases reflected higher rates, including fuel surcharges,
increased traffic volume (up 6% for the quarter and 3% for the first nine
months) and $22 million related to a coal customer's 2008 contracted-volume
shortfall and a nonrecurring effect related to the implementation of NS' new
coal billing system. The higher rates were comprised of pricing increases and
contract escalators and the effect of increased longer-haul export coal traffic.
For both periods, tonnage handled increased, reflecting improved export
volume. Coal tonnage by market was as follows:
Third Quarter First Nine Months
2008 2007 2008 2007
(tons in thousands)
Utility 35,902 35,577 107,578 107,758
Export 6,262 4,050 18,236 11,372
Steel 5,241 4,856 13,503 13,558
Industrial 2,271 2,362 6,430 7,412
49,676 46,845 145,747 140,100
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Utility coal tonnage increased slightly in the third quarter but was essentially
flat in the first nine months as higher export demand further tightened coal
availability for domestic customers. Export coal tonnage increased 55% for the
third quarter and 60% for the first nine months, reflecting increased global
demand coupled with weather-related supply constraints in Australia, reduced
export volume from China and the continued weak dollar. D omestic
metallurgical coal, coke and iron ore tonnage increased 8% in the third quarter
due to the start up of a new coke plant, coal sourcing changes and new business.
Industrial coal tonnage decreased 4% for the third quarter and 13% in the
first nine months compared with 2007, principally due to coal supply
constraints.
NS is currently involved in litigation with Virginia Electric and Power Company/Old Dominion Electric Cooperative (Virginia Power) regarding rate adjustment provisions in a transportation contract between them. In 2007, the Virginia Supreme Court issued a decision that remanded the case to the trial court on the grounds that neither of its prior decisions constituted a final order. On April 17, 2008, the trial court entered a final order granting NS monetary damages, including interest, and prescribing the methodology for determining future rates. Virginia Power filed its Notice of Appeal on May 7, 2008. Future developments and the ultimate resolution of this matter could result in NS recognizing additional revenues related to this dispute, which could have a favorable impact on results of operations in a particular year or quarter.
Coal revenues for the remainder of the year are expected to be up compared to prior year levels, due to higher average revenue per unit and continued strength in the domestic and metallurgical markets.
General Merchandise
General merchandise revenues increased $167 million, or 13%, in the third
quarter and $429 million, or 11%, in the first nine months, compared with the
same periods last year, a result of higher average revenue per unit. The
improvement in average revenue per unit reflected higher fuel surcharges and
continued market-based pricing in all groups . Traffic volume declined 6% for
the quarter and 4% for the first nine months, driven primarily by lower
automotive volumes. Chemicals traffic volume decreased 5% for the third
quarter and 4% for the first nine months, reflecting continued weakness in both
plastics (linked to housing construction declines) and industrial intermediate
products. Metals and construction volume was up slightly in both periods as
increased carloads from metals, principally scrap, offset declines in
housing-related markets. A griculture, consumer products and government volume
increased 5% for both the third quarter and first nine months, reflecting
increases in ethanol and military shipments. Automotive volumes decreased 30%
for the third quarter and 20% for the first nine months, reflecting reduced
North American sales and production. Automotive manufacturers, especially the
domestic producers, continue to experience sales declines. Ford, General Motors
and Chrysler combined operate 16 of 26 assembly plants served by NS. Four of
these assembly plants implemented shift reductions during the first nine months
of 2008, and two other plants have announced plans to reduce shifts in the
fourth quarter. In addition, one manufacturer has announced plans to close an
assembly plant in the fourth quarter, and a second manufacturer has announced
plans to idle an assembly plant as it retools to produce a new product in 2010.
NS continues to monitor the state of the automotive industry and the
collectability of the associated receivables. P aper, clay and forest traffic
volume was down 6% for the third quarter and 7% for the first nine months,
reflecting lower volumes related to the housing slowdown and continued decline
in conventional paper markets.
General merchandise revenues are expected to be higher for the remainder of the year compared with 2007 as improved pricing should continue to offset lower traffic volume.
Intermodal
Intermodal revenues increased $76 million, or 16%, in the third quarter and
$153 million, or 11%, for the first nine months, compared with the same periods
last year, primarily due to higher average revenue per unit including fuel
surcharges. Intermodal volume was flat in the third quarter, but declined 2%
in the first nine months. Domestic volume (which includes truckload and
intermodal marketing companies' [IMC] volumes) increased 18% for the third
quarter and 6% for the first nine months, reflecting the relative efficiency of
intermodal versus over-the-road transportation in a high fuel cost environment.
International traffic volume declined 9% for the third quarter and 7% for the
first nine months, primarily driven by a soft economy and less inland rail
movement of West Coast port traffic that offset East Coast port volume growth.
The Premium business, which includes parcel and less-than-truckload (LTL)
carriers, decreased 2% for the third quarter and 3% for the first nine months,
as reduced private empty movements and soft parcel business offset LTL
conversions. Triple Crown Services Company volume was down 5% for the third
quarter and 1% for the first nine months primarily driven by reduced auto parts
shipments.
Intermodal revenues for the remainder of the year are expected to continue to reflect growth due to increased revenue per unit and stronger domestic volumes related to truckload conversion to intermodal.
Railway Operating Expenses
Third-quarter railway operating expenses were $2.0 billion in 2008, up $328 million, or 20%, compared with the same period last year. For the first nine months, railway operating expenses were $5.9 billion, up $809 million, or 16%, compared with the same period last year.
Compensation and benefits expenses increased $89 million, or 14%, in the third quarter and $146 million, or 8%, in the first nine months, compared with the same periods last year. The changes reflected primarily the cost of lump-sum payments due under a new labor agreement with the Brotherhood of Locomotive Engineers and Trainmen (BLET) ($28 million), increased incentive compensation due to a higher projected payout (up $25 million for the quarter and $47 million for the first nine months), increased wage rates (up $18 million for the quarter and $38 million for the first nine months), and increased stock-based compensation primarily due to stock price increases during the periods (up $9 million for the quarter and $36 million for the first nine months).
Purchased services and rents increased $28 million, or 7%, in the third quarter and $39 million, or 3%, in the first nine months, compared with the same periods last year. The increases were primarily driven by higher intermodal terminal costs, transportation operating costs and professional and legal services that were partially offset by lower equipment rents.
Fuel expense, which includes the cost of locomotive fuel as well as other fuel used in railway operations, increased $185 million, or 64%, for the third quarter and $553 million, or 68%, for the first nine months, compared with the same periods last year, reflecting sharply higher fuel prices.
Materials and other expenses (including the estimates of costs related to personal injury, property damage and environmental matters) increased $19 million, or 11%, in the third quarter and $51 million, or 8%, for the first nine months, compared with the same periods last year. The increases reflected increased materials costs for locomotive and freight car repairs as well as higher expenses associated with derailments and employee travel and relocation costs. The year-to-date increase also reflected costs associated with the Avondale Mills settlement related to the Graniteville accident (see additional discussion below) offset in part by favorable personal injury claims development. The following table shows the components of materials and other expenses.
Third Quarter First Nine Months
2008 2007 2008 2007
(in millions)
Materials $ 96 $ 88 $ 293 $ 268
Casualties and other claims 34 33 141 131
Other 68 58 218 202
$ 198 $ 179 $ 652 $ 601
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In April 2008, NS settled the lawsuit brought by Avondale Mills for claims associated with the Jan. 6, 2005, derailment in Graniteville, SC. A portion of the settlement will not be reimbursed by insurance and was included in first-quarter 2008 expenses. The total liability related to the derailment 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 the unreimbursed portion and NS' self-insured retention, including NS' response costs and legal fees. The Consolidated Balance Sheets reflect current and long-term receivables for estimated recoveries from NS' insurance carriers. On July 1, 2008, NS filed a demand for arbitration against one of its insurance carriers that failed to respond to an insurance claim submitted by NS. Although t he arbitral tribunal has been appointed, the carrier has not yet filed its grounds of defense. However, it is likely that all or part of the recorded recovery attributable to such carrier ($100 million) will be contested. NS believes these expenses are covered by the insurance policy and that recovery of any contested amount is probable, in that if the carrier contests payment an arbitrator would determine the settlement amounts to be reasonable and that the insurer's refusal to consent to and to fund the settlement was a breach of contract. In October 2008, another of NS' insurance carriers provided the preliminary findings of its review of NS' reimbursement request and reported that it may dispute a portion of that request. NS believes that all expenses contained in the reimbursement request are covered by the insurance policy and that recovery is probable.
Other income - net
Other income - net increased $8 million in the third quarter and $33 million in the first nine months of 2008, compared with the same periods in 2007. The increases reflect the absence of expenses related to synthetic fuel investments (down $18 million for the quarter and $64 million for the first nine months), reduced interest expense (down $11 million for the quarter and $21 million for the first nine months) due to second- and third-quarter adjustments to reflect the outcome of certain tax examinations and higher coal royalties (up $5 million for the quarter and $6 million for the first nine months). These benefits were partially offset by fewer gains on the sale of property and investments (down $20 million for the quarter and $12 million for the first nine months), lower returns and higher borrowing costs on corporate-owned life insurance (down $8 million for the quarter and $40 million for the first nine months) and lower interest income (down $5 million for the quarter and $22 million for the first nine months).
Provision for Income Taxes
The third-quarter and year-to-date effective income tax rates were 36.7% and 37.8% in 2008, compared with 36.2% and 34.5% for the same periods last year. The increases were largely due to the absence of synthetic fuel-related credits which expired at the end of 2007, offset by the tax benefit arising from the donation of a conservation easement as well as the absence of an Illinois tax law change which increased deferred taxes by $19 million in the third quarter of 2007.
The Internal Revenue Service completed its audit of NS' consolidated federal income tax returns for 2004 and 2005 during the third quarter (see Note 2), and the 2006 and 2007 tax years are now being audited.
FINANCIAL CONDITION AND LIQUIDITY
Cash provided by operating activities, NS' principal source of liquidity, was $2.1 billion for the first nine months of 2008 and $1.8 billion for the first nine months of 2007. NS had a working capital deficit of $221 million at Sept. 30, 2008, compared with a working capital deficit of $273 million at Dec. 31, 2007; the change was largely the result of increased proceeds from borrowings and cash flows from operations that were largely offset by higher debt repayments, property additions and share repurchases. The payment of the Avondale Mills settlement affected working capital because the amount subject to arbitration is classified as a long-term receivable. NS' cash, cash equivalents and short-term investment balances totaled $557 million at Sept. 30, 2008. NS expects that cash on hand combined with cash flows from operations will be sufficient to meet its ongoing obligations. In addition to the contractual obligation amounts and information relating to NS' future obligations related to certain tax positions contained in NS' Form 10-K as of Dec. 31, 2007, NS (1) made additional purchase commitments for capital assets, discussed below, (2) through a private offering issued and sold $600 million in debt securities during the second quarter of 2008, and (3) decreased the unrecognized tax benefit by $33 million to $134 million primarily due to resolution of the 2004 and 2005 federal income tax audits. The year of settlement of the $134 million unrecognized tax benefit cannot be reasonably estimated.
Cash used for investing activities was $810 million for the first nine months of 2008, compared with $600 million in the same period last year, reflecting higher property additions. In the first quarter of 2008, Norfolk Southern's Board of Directors approved the addition of $64 million to its 2008 capital budget to accelerate the purchase of approximately 750 new coal cars. In July 2008, the Board of Directors authorized the addition of approximately $80 million to the 2008 capital budget, three quarters of which is to acquire new locomotives and the remainder to accelerate program track work.
Cash used for financing activities was $914 million for the first nine months of 2008, compared with $1.3 billion for the same period of 2007. The change reflected net debt issuances of $99 million in 2008 compared with debt repayments of $454 million in 2007. Additionally, NS share repurchases for the first nine months of 2008 were $130 million higher than for the first nine months of 2007. The timing and volume of future share repurchases will be guided by management's assessment of market conditions and other factors. Near-term purchases under the share repurchase program are expected to be made with internally generated cash and proceeds from financings. NS' debt-to-total capitalization ratio was 39.2% at Sept. 30, 2008, compared with 39.6% at Dec. 31, 2007.
NS has in place and available a $1 billion, five-year credit agreement expiring in 2012, which provides for borrowings at prevailing rates and includes covenants. NS had no amounts outstanding under this facility at Sept. 30, 2008, and NS is in compliance with all of the covenants. Through February 2009, NS is ineligible to utilize its March 2001 and September 2004 Form S-3 registration statements due to a late filing of a Form 8-K which was unrelated to its financial condition or results of operations. However, this is not expected to have an impact on financial liquidity. Through a private offering, NS issued and sold $600 million in debt securities in April 2008 (see Note 7), and subsequently exchanged substantially all of these unregistered securities with essentially identical securities registered under the Securities Act of 1933. In October 2008, NS renewed and amended its accounts receivable securitization facility, with a new 364-day term to run until October 2009.
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 regularly discusses the development, selection and disclosures concerning critical accounting estimates with the Audit Committee of its Board of Directors. There have been no significant changes to the Application of Critical Accounting Estimates disclosure contained in NS' Form 10?K as of Dec. 31, 2007.
OTHER MATTERS
Labor Agreements
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 changes.
NS recently reached an agreement with the BLET that extends its contract through 2014. The new BLET agreement covers approximately 5,000 engineers and provides each the opportunity for an annual bonus payment based on company financial and service performance metrics and his or her work availability in the previous year. In addition, in October 2008, members of the International Association of Machinists and Aerospace Workers (IAM) ratified an agreement with NS.
The most recent bargaining round began in late 2004. Since that time, the railroads have reached agreements that extend through 2009 with all of the rail unions. Because NS has reached separate agreements with the BLET and the American Train Dispatchers Association (ATDA), only the health and welfare provisions from the national agreements apply to NS' locomotive engineers and ATDA-represented dispatchers.
Market Risks and Hedging Activities
NS uses derivative financial instruments to manage its overall exposure to fluctuations in interest rates. 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 Sept. 30, 2008, NS' debt subject to interest rate fluctuations totaled $122 million. A 1% increase in interest rates would increase NS' total annual interest expense related to all its variable debt by approximately $1 million. Management considers it unlikely that interest rate fluctuations applicable to these instruments will result in a material adverse effect on NS' financial condition, 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 Sept. 30, 2008, the average pay rate under these agreements was 3%, and the average receive rate was 7%. The effect of the swaps was to reduce interest expense by less than $1 million in the third quarter and first nine months of both 2008 and 2007. A portion of the lease obligations is payable in . . .
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