The following discussion should be read in conjunction with the Consolidated Financial Statements and applicable notes to the Financial Statements and Supplementary Data, Item 8, and other information in this report, including Risk Factors set forth in Item 1A and Critical Accounting Policies and Cautionary Information at the end of this Item 7.

The Railroad, along with its subsidiaries and rail affiliates, is our one reportable operating segment. Although we analyze revenue by commodity group, we analyze the net financial results of the Railroad as one segment due to the integrated nature of our rail network.

EXECUTIVE SUMMARY

2008 Results

• Safety - We operated a safer railroad in 2008, improving safety for all of our employees, customers, and the communities where we operate. The employee injury incident rate per 200,000 man-hours declined 11% from 2007 to its lowest level ever. A continued focus on derailment prevention in 2008 resulted in a 14% reduction in incidents, with associated costs declining 7%. With respect to public safety, we closed 435 grade crossings to reduce our exposure to incidents. We also continued installing video cameras in our road locomotives and now have camera-equipped locomotives in the lead position of over 90% of our road trains. These video cameras allow us to better analyze grade crossing conditions and incidents, increasing safety for our employees and the public. The number of grade crossing incidents decreased 18% during the year, to the lowest number on record. Also, through extensive trespass reduction programs, we were able to reduce trespasser incidents by 9%. All of these improvements are the result of comprehensive efforts to enhance employee training, increase public education, make targeted capital investments, and take proactive steps to eliminate or reduce safety risks.

• Financial Performance - In 2008, we generated operating income of $4.1 billion despite the recessionary economy. Yield increases, network management initiatives, and improved productivity drove the 21% increase in operating income, more than offsetting a 5% reduction in volume levels, which reflects deteriorating economic conditions during the year, particularly in the fourth quarter. Our operating ratio was 77.3% for the year, a 2 point improvement compared to 2007. Net income of $2.3 billion also exceeded our previous milestone, translating into earnings of $4.54 per diluted share.

• Freight Revenues - Our freight revenues grew 11% year-over-year to $17.1 billion. We achieved record revenue levels in five of our six commodity groups, driven by better pricing and fuel cost recovery. Since 2004, we have repriced approximately 82% of our business. Overall, volume decreased 5% in 2008 due to the weakening economy, driving lower demand in several market sectors, particularly the automotive, domestic housing and construction markets.

• Network Operations - In 2008, we significantly improved the fluidity and efficiency of our transportation network. Continued focus on increasing velocity, eliminating work events, improving asset utilization, and expanding capacity were key drivers of our operational improvement. Lower volume levels also contributed to the increased efficiency. We increased average train speed by 8%, reduced average terminal dwell time by 1%, and improved car utilization by 4% with ongoing enhancements to our Unified Plan (an ongoing program that streamlines segments of our transportation plan) and by implementing initiatives to make train processing at our terminals more efficient. We also expanded capacity and continued to use industrial engineering techniques to further improve network fluidity and improve asset utilization. Our customer satisfaction improved to record

• Fuel Prices - Crude oil prices increased at a steady rate through the first seven months of 2008, closing at a record high of $145.29 a barrel in early July. As the economy worsened during the third and fourth quarters, fuel prices dropped dramatically, hitting $33.87 per barrel in December, a near five-year low. Despite these price declines toward the end of the year, our 2008 average fuel price increased by 39% and added $1.1 billion of operating expenses compared to 2007. Our fuel surcharge programs helped offset the impact of higher fuel prices. In addition, we reduced our consumption rate by 4%, saving approximately 58 million gallons of fuel during the year. The use of newer, more fuel efficient locomotives; our fuel conservation programs; improved network operations; and a shift in commodity mix, primarily due to growth in bulk shipments, contributed to the improvement.

• Free Cash Flow - Cash generated by operating activities totaled a record $4.1 billion, yielding free cash flow of $825 million in 2008. Free cash flow is defined as cash provided by operating activities, less cash used in investing activities and dividends paid.

Free cash flow is not considered a financial measure under accounting principles generally accepted in the United States (GAAP) by SEC Regulation G and Item 10 of SEC Regulation S-K. We believe free cash flow is important in evaluating our financial performance and measures our ability to generate cash without additional external financings. Free cash flow should be considered in addition to, rather than as a substitute for, cash provided by operating activities. The following table reconciles cash provided by operating activities (GAAP measure) to free cash flow (non-GAAP measure):

             Millions of Dollars                          2008          2007          2006
             Cash provided by operating activities   $   4,070     $   3,277     $   2,880
             Cash used in investing activities          (2,764 )      (2,426 )      (2,042 )
             Dividends paid                               (481 )        (364 )        (322 )
             Free cash flow                          $     825     $     487     $     516

2009 Outlook

• Safety - Operating a safe railroad benefits our employees, our customers, our shareholders, and the public. We will continue using a multi-faceted approach to safety, utilizing technology, risk assessment, quality control, and training and engaging our employees. We plan to continue implementation of Total Safety Culture (TSC) throughout our operations. TSC, an employee-focused initiative that has helped improve safety, is a process designed to establish, maintain, and promote safety among co-workers. With respect to public safety, we will continue our efforts to maintain, upgrade, and close crossings, install video cameras on locomotives, and educate the public about crossing safety through various Railroad and industry programs, along with other activities.

• Transportation Plan - In 2009, we will continue to evaluate traffic flows and network logistic patterns to identify additional opportunities to simplify operations and improve network efficiency and asset utilization. We plan to maintain adequate manpower and locomotives, and improve productivity using industrial engineering techniques.

• Fuel Prices - On average, we expect fuel prices to decrease substantially from the average price we paid in 2008. However, due to economic uncertainty, other global pressures, and weather incidents, fuel prices again could be volatile during the year. To reduce the impact of fuel price on earnings, we

• Capital Plan - In 2009, we expect our total capital investments to be approximately $2.8 billion (which may be revised if business conditions or new laws or regulations affect our ability to generate sufficient returns on these investments). See further discussion in this Item 7 under Liquidity and Capital Resources - Capital Plan.

• Financial Expectations - We are cautious about the economic environment; however, we anticipate continued pricing opportunities, network improvement, and increased productivity in 2009.

RESULTS OF OPERATIONS

Operating Revenues




                                                                   % Change      % Change
   Millions of Dollars         2008         2007         2006   2008 v 2007   2007 v 2006
   Freight revenues      $   17,118   $   15,486   $   14,791           11%            5%
   Other revenues               852          797          787           7             1
   Total                 $   17,970   $   16,283   $   15,578           10%            5%

Freight revenues are revenues generated by transporting freight or other materials from our six commodity groups. Freight revenues vary with volume (carloads) and average revenue per car (ARC). ARC is driven by changes in price, traffic mix and fuel surcharges. As a result of contractual obligations with some of our customers, we have provided incentives for meeting or exceeding specified cumulative volumes or shipping to and from specific locations, which we record as a reduction to freight revenues based on the actual or projected future shipments. We recognize freight revenues on a percentage-of-completion basis as freight moves from origin to destination. We allocate freight revenues between reporting periods based on the relative transit time in each reporting period and recognize expenses as we incur them.

Other revenues include revenues earned by our subsidiaries, revenues from our commuter rail operations, and accessorial revenues, which we earn when customers retain equipment owned or controlled by us or when we perform additional services such as switching or storage. We recognize other revenues as we perform services or meet contractual obligations.

Freight revenues from five of the six commodity groups increased during 2008, with particularly strong growth from agricultural and energy shipments. While revenues generated from chemical and industrial products shipments grew in 2008 compared to 2007, Hurricanes Gustav and Ike reduced shipments of these commodities. Revenues generated from automotive shipments declined versus 2007. Greater fuel cost recoveries and core pricing improvement combined to increase ARC during 2008. Fuel cost recoveries include fuel surcharge revenue and the impact of resetting the base fuel price for certain traffic, as described below in more detail. The severe economic downturn during the fourth quarter compounded already declining volumes experienced during the first nine months of 2008 due to ongoing weakness in certain market sectors. As a result, we moved fewer intermodal, automotive, industrial products, and chemical shipments, which more than offset volume growth from agricultural and energy shipments.

Our fuel surcharge programs (excluding index-based contract escalators that contain some provision for fuel) generated $2.3 billion in freight revenues during 2008. Fuel surcharge revenue is not comparable to prior periods due to the implementation of new mileage-based fuel surcharge programs beginning in April 2007 for regulated traffic. As previously disclosed in our 2006 Annual Report on Form 10-K, the STB

issued a decision limiting the manner in which U.S. railroads can calculate fuel surcharges on traffic regulated by the STB. Effective April 26, 2007, we implemented new fuel surcharge programs covering this regulated traffic, which represents approximately 19% of our revenue base. These new programs use mileage (as opposed to percent of revenue) as the basis for calculating fuel surcharges, and they use the On-Highway Diesel Price index - published by the Energy Information Administration - for purposes of determining fuel costs. The new programs affect fuel surcharges assessed for certain shipments of agricultural, chemical, and industrial products, and, to a lesser extent, coal. In addition, we reset the effective base fuel price at which our new mileage-based fuel surcharge programs take effect, resulting in a higher starting point of $2.30 per gallon versus $1.35 per gallon. We also converted a portion of our non-regulated traffic to mileage-based fuel surcharge programs. The resetting of the fuel price at which the fuel surcharge begins, in conjunction with rebasing the affected transportation rates to include a portion of what had been in the fuel surcharge, did not materially change our freight revenues, as higher base rates offset lower fuel surcharge revenue.

Freight revenues from five of our six commodity groups increased during 2007, while revenues generated from industrial products shipments declined. ARC increased 6% during 2007 driven by core price improvement. Lower shipments of industrial and agricultural products drove volume down 1% in 2007, more than offsetting an increase in chemical shipments. Our fuel surcharge programs
(excluding index-based contract escalators that contain some provision for fuel)
generated $1.5 billion in freight revenues in 2007. Fuel surcharge revenues are not comparable to prior periods due to implementation of new mileage-based fuel surcharge programs for certain traffic, as described above.

Other revenues increased in 2008 versus 2007 driven by higher revenues from both our commuter rail operations and our subsidiary that brokers intermodal services. Accessorial revenues also increased in both periods due to improved collection rates.

The following tables summarize the year-over-year changes in freight revenues, revenue carloads, and ARC by commodity type:

      Freight Revenues                                          % Change      % Change
      Millions of Dollars       2008       2007       2006   2008 v 2007   2007 v 2006
      Agricultural          $  3,174   $  2,605   $  2,385          22 %            9  %
      Automotive               1,344      1,458      1,427         (8)              2
      Chemicals                2,494      2,287      2,084          9              10
      Energy                   3,810      3,134      2,949         22               6
      Industrial Products      3,273      3,077      3,135          6              (2)
      Intermodal               3,023      2,925      2,811          3               4
      Total                 $ 17,118   $ 15,486   $ 14,791          11 %            5  %


      Revenue Carloads                                          % Change      % Change
      Thousands                 2008       2007       2006   2008 v 2007   2007 v 2006
      Agricultural               947        902        923           5 %           (2) %
      Automotive                 667        826        834        (19)             (1)
      Chemicals                  885        928        896         (5)              4
      Energy                   2,348      2,299      2,296          2               -
      Industrial Products      1,249      1,325      1,446         (6)             (8)
      Intermodal               3,165      3,453      3,457         (8)              -
      Total                    9,261      9,733      9,852          (5)%           (1) %

                                                                % Change      % Change
     Average Revenue per Car      2008      2007      2006   2008 v 2007   2007 v 2006
     Agricultural              $ 3,352   $ 2,888   $ 2,584          16 %           12  %
     Automotive                  2,017     1,766     1,710         14               3
     Chemicals                   2,818     2,464     2,326         14               6
     Energy                      1,622     1,363     1,285         19               6
     Industrial Products         2,620     2,322     2,167         13               7
     Intermodal                    955       847       813         13               4
     Average                   $ 1,848   $ 1,591   $ 1,501          16 %            6  %

Agricultural Products - Price
improvements, fuel surcharges, and
volume growth generated higher
agricultural freight revenue in 2008
versus 2007. Strong global demand for
grain and a weak dollar drove higher
shipments of corn and feed grains and
shipments of wheat and food grains for
2008. Shipments of ethanol, a grain
product used as an alternative fuel and
fuel additive, and its co-products
(primarily livestock feed) also
increased.

Automotive - Double-digit declines in
shipments of both finished vehicles and
auto parts drove freight revenue lower
in 2008 compared to 2007. Price
improvements and fuel surcharges
partially offset these lower volumes.
The manufacturers experienced poor sales
and reduced vehicle production during
2008 due to the recessionary economy,
which in turn reduced shipments of
finished vehicles and parts. In
addition, a major parts supplier strike
reduced volume levels compared to 2007.            2008 Automotive Revenue
Shipments of finished vehicles decreased
23% in 2008 versus 2007.                           [[Image Removed: LOGO]]

In 2007, price increases drove the
growth in automotive revenue, partially
offset by lower finished vehicle
shipments versus 2006. A decline in
vehicle production levels primarily
drove the volume decline. Conversely,
automotive parts shipments grew due to
increased volumes from domestic
manufacturers, new business acquired in
the middle of 2006, and our new
intermodal train service between Mexico
and Michigan.

Energy - Price increases, fuel
surcharges, and higher volume produced
revenue growth in 2008 versus 2007.
Shipments from the SPRB were up 5%
compared to 2007 despite mine flooding
and network interruptions caused by
extensive flooding in the Midwest in
June of 2008. Conversely, shipments from
the Colorado and Utah mines were down 4%
in 2008 versus 2007, due to mine
production problems.                                 2008 Energy Revenue

Price increases during 2007 improved               [[Image Removed: LOGO]]
both revenue and ARC over 2006 levels.
Volume was flat, however, as severe
storms in the first quarter and heavy
rains in May flooded coal pits in the
SPRB, which closed several rail lines
and reduced volume levels. Shipments
from the Colorado and Utah mines were
down 1% due to lower mine production,
predominately in the fourth quarter of
2007.

Industrial Products - Price improvements
and fuel surcharges contributed to
higher freight revenue in 2008 compared
to 2007. Lower volume partially offset
these increases. Continued softening of
the housing market and weak market
conditions resulted in lower lumber
shipments. In addition, cement and stone
shipments declined due to a weak overall
residential and commercial construction
market. Business interruptions resulting
from the hurricanes also reduced various
construction-related shipments,
primarily stone. Conversely, we shipped
more steel in 2008 than in 2007 as the
weak dollar increased the cost of steel       2008 Industrial Products Revenue
imports during most of the year,
creating a strong demand for domestic              [[Image Removed: LOGO]]
steel.

Volume declines more than offset price
increases, driving industrial products
revenue lower in 2007 compared to 2006.
Continued softening of the housing
construction market, surplus
inventories, and general market
uncertainty resulted in lower lumber
shipments. Delays of rail expansion
projects, customer production problems,
unfavorable weather, and the ongoing
impact of a weak residential
construction market reduced stone
shipments during the year.




Intermodal - Price increases and fuel
surcharges generated higher revenue in
2008, partially offset by lower volume
levels. International traffic declined
11% in 2008, reflecting continued
softening of imports from China and the
loss of a customer contract. Notably,
the peak intermodal shipping season,
which usually starts in the third
quarter, was particularly weak in 2008.
Additionally, continued weakness in                2008 Intermodal Revenue
domestic housing and automotive sectors
translated into weak demand in large               [[Image Removed: LOGO]]
sectors of the international intermodal
market, which also contributed to lower
volumes. Domestic traffic declined 3% in
2008 due to the loss of a customer
contract and lower volumes from
less-than-truckload shippers.
Additionally, the flood-related embargo
on traffic in the Midwest during the
second quarter hindered intermodal
volume levels in 2008.

Price increases improved intermodal revenue in 2007 compared to 2006. Volume was flat versus 2006 as increased domestic traffic due to new service offerings and increased business under some of our older, long-term contracts were offset by a decrease of premium shipments. International traffic was flat in 2007 compared to 2006 due to general softening of imports from Asia.

Mexico Business - The results for each commodity group include shipments to and from Mexico. Revenue from Mexico business increased 13% to $1.6 billion in 2008 compared to 2007. Price improvements and fuel surcharges contributed to these increases, partially offset by a 4% decline in volume in 2008 compared to 2007.

Revenue from Mexico business increased 5% to $1.44 billion in 2007 compared to 2006. Price increases and more shipments of automotive parts and intermodal containers drove revenue growth in 2007.

Volume declines in cement, some agricultural products, and newsprint shipments partially offset the increases.

Operating Expenses




                                                                                % Change       % Change
Millions of Dollars                        2008         2007         2006    2008 v 2007    2007 v 2006
Compensation and benefits             $   4,457    $   4,526    $   4,535           (2)%             -  %
Fuel                                      3,983        3,104        2,968          28                 5
Purchased services and materials          1,902        1,856        1,756           2                 6
Depreciation                              1,387        1,321        1,237           5                 7
Equipment and other rents                 1,326        1,368        1,396          (3)               (2 )
Other                                       840          733          802          15                (9 )
Total                                 $  13,895    $  12,908    $  12,694            8 %              2 %




Operating expenses increased $987 million in                    2008 Operating Expenses
2008. Our fuel price per gallon rose 39% during
the year, increasing operating expenses by $1.1                 [[Image Removed: LOGO]]
billion compared to 2007. Wage, benefit, and
materials inflation, higher depreciation, and
costs associated with the January Cascade
mudslide and Hurricanes Gustav and Ike also
increased expenses during the year. Cost
savings from productivity improvements, better
resource utilization, and lower volume helped
offset these increases.

Operating expenses increased $214 million in
2007 versus 2006. Higher fuel prices, which
rose 9% during the period, increased operating
expenses by $242 million. Wage, benefit and
materials  inflation  and  higher  depreciation
expense also increased expenses during the
year. Productivity improvements, better
resource utilization, and a lower fuel
consumption rate helped offset these increases.

Compensation and Benefits - Compensation and benefits include wages, payroll taxes, health and welfare costs, pension costs, other postretirement benefits, and incentive costs. Productivity initiatives in all areas, combined with lower volume, led to a 4% decline in our workforce for 2008, saving $227 million compared to 2007. Conversely, general wage and benefit inflation and higher pension and postretirement benefits increased expenses in 2008, partially offsetting these reductions.

Operational improvements and lower volume levels in 2007 led to a 1% decline in our workforce, saving $79 million in 2007 compared to 2006. A smaller workforce and less need for new train personnel reduced training costs during the year, which contributed to the improvement. General wage and benefit inflation mostly offset the reductions, reflecting higher salaries and wages and the impact of higher healthcare and other benefit costs.

Fuel - Fuel includes locomotive fuel and gasoline for highway and non-highway vehicles and heavy equipment. Diesel fuel prices, which averaged $3.15 per gallon (including taxes and transportation costs) in 2008 compared to $2.27 per gallon in 2007, increased expenses by $1.1 billion. A 4% improvement in our fuel consumption rate resulted in $136 million of cost savings due to the use of newer, more fuel

. . .