UNITED STATES | |||
SECURITIES AND EXCHANGE COMMISSION | |||
Washington , D.C. 20549 | |||
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FORM 10-Q |
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(X) | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES |
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| EXCHANGE ACT OF 1934 |
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| For the quarterly period ended |
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( ) | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES |
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| EXCHANGE ACT OF 1934 |
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| For the transition period from _________ to _________ |
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Commission file number 1-8339 |
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NORFOLK SOUTHERN CORPORATION | ||
(Exact name of registrant as specified in its charter) | ||
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Virginia | 52-1188014 | |
(State or other jurisdiction of incorporation) | (IRS Employer Identification No.) | |
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Three Commercial Place |
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Norfolk , Virginia | 23510-2191 | |
(Address of principal executive offices) | Zip Code | |
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Registrant's telephone number, including area code | (757) 629-2680 | |
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No Change | ||
(Former name, former address and former fiscal year, if changed since last report.) | ||
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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes (X) No ( ) | ||
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Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. Large accelerated filer [X] Accelerated filer [ ] Non-accelerated filer [ ] | ||
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Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ( ) No (X) | ||
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Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. | ||
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Class | Outstanding at | |
Common Stock (par value $1.00) | registrant’s consolidated subsidiaries) | |
TABLE OF CONTENTS
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES (NS)
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Part I. | Financial information: |
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| Item 1. | Financial statements: |
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| Consolidated Statements of Income |
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| Three and | 3 | |
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| Consolidated Balance Sheets |
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| As of | 4 | |
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| Consolidated Statements of Cash Flows |
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| Notes to Consolidated Financial Statements | 6 | |
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| Report of Independent Registered Public Accounting Firm | 18 | |
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| Item 2. | Management’s Discussion and Analysis of Financial Condition and |
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| Results of Operations | 19 | |
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| Item 3. | Quantitative and Qualitative Disclosures About Market Risks |
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| Item 4. | Controls and Procedures |
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Part II. | Other information: |
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| Item 1. | Legal Proceedings | 30 | |
Item 1A. | Risk Factors |
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| Item 2. | Unregistered Sales of Equity Securities and Use of Proceeds | | |
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| Item 6. | Exhibits |
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Signatures |
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Exhibit Index |
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2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements.
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Income
(Unaudited)
| Three Months Ended | Six Months Ended | Three Months Ended | Nine Months Ended | ||||||||||||
| June 30, | June 30, | Sept. 30, | Sept. 30, | ||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | ||||||||
| ($ in millions, except per share amounts) | ($ in millions, except per share amounts) | ||||||||||||||
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Railway operating revenues: |
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Coal | $ | 584 | $ | 578 | $ | 1,143 | $ | 1,045 | $ | 595 | $ | 546 | $ | 1,738 | $ | 1,591 |
General merchandise |
| 1,311 |
| 1,148 |
| 2,589 |
| 2,234 |
| 1,283 |
| 1,138 |
| 3,872 |
| 3,372 |
Intermodal |
| 497 |
| 428 |
| 963 |
| 836 |
| 515 |
| 471 |
| 1,478 |
| 1,307 |
Total railway operating revenues |
| 2,392 |
| 2,154 |
| 4,695 |
| 4,115 |
| 2,393 |
| 2,155 |
| 7,088 |
| 6,270 |
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Railway operating expenses: |
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Compensation and benefits |
| 637 |
| 624 |
| 1,358 |
| 1,228 |
| 624 |
| 629 |
| 1,982 |
| 1,857 |
Materials, services and rents |
| 471 |
| 446 |
| 942 |
| 882 |
| 472 |
| 462 |
| 1,414 |
| 1,344 |
Conrail rents and services (Note 2) |
| 31 |
| 31 |
| 63 |
| 66 |
| 30 |
| 31 |
| 93 |
| 97 |
Depreciation |
| 182 |
| 194 |
| 365 |
| 387 |
| 186 |
| 195 |
| 551 |
| 582 |
Diesel fuel |
| 260 |
| 162 |
| 491 |
| 312 |
| 257 |
| 189 |
| 748 |
| 501 |
Casualties and other claims (Note 9) |
| 65 |
| 40 |
| 118 |
| 118 |
| 50 |
| 59 |
| 168 |
| 177 |
Other |
| 69 |
| 65 |
| 130 |
| 127 |
| 59 |
| 62 |
| 189 |
| 189 |
Total railway operating expenses |
| 1,715 |
| 1,562 |
| 3,467 |
| 3,120 |
| 1,678 |
| 1,627 |
| 5,145 |
| 4,747 |
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Income from railway operations |
| 677 |
| 592 |
| 1,228 |
| 995 |
| 715 |
| 528 |
| 1,943 |
| 1,523 |
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Other income – net |
| 33 |
| 9 |
| 68 |
| 11 |
| 41 |
| 32 |
| 109 |
| 43 |
Interest expense on debt |
| 121 |
| 126 |
| 241 |
| 254 |
| 120 |
| 119 |
| 361 |
| 373 |
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Income before income taxes |
| 589 |
| 475 |
| 1,055 |
| 752 |
| 636 |
| 441 |
| 1,691 |
| 1,193 |
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Provision for income taxes |
| 214 |
| 51 |
| 375 |
| 134 |
| 220 |
| 140 |
| 595 |
| 274 |
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Net income | $ | 375 | $ | 424 | $ | 680 | $ | 618 | $ | 416 | $ | 301 | $ | 1,096 | $ | 919 |
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Per share amounts (Note 5): |
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Net income |
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Basic | $ | 0.91 | $ | 1.05 | $ | 1.65 | $ | 1.54 | $ | 1.04 | $ | 0.74 | $ | 2.68 | $ | 2.28 |
Diluted | $ | 0.89 | $ | 1.04 | $ | 1.61 | $ | 1.51 | $ | 1.02 | $ | 0.73 | $ | 2.62 | $ | 2.24 |
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Dividends | $ | 0.16 | $ | 0.11 | $ | 0.32 | $ | 0.22 | $ | 0.18 | $ | 0.13 | $ | 0.50 | $ | 0.35 |
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See accompanying notes to consolidated financial statements. | See accompanying notes to consolidated financial statements. | See accompanying notes to consolidated financial statements. |
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
(Unaudited)
| June 30, | Dec. 31, | Sept. 30, | Dec. 31, | ||||
| 2006 | 2005 | 2006 | 2005 | ||||
| ($ in millions) | ($ in millions) | ||||||
Assets |
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Current assets: |
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Cash and cash equivalents | $ | 257 | $ | 289 | $ | 270 | $ | 289 |
Short-term investments |
| 1,278 |
| 968 |
| 533 |
| 968 |
Accounts receivable, net (Note 9) |
| 990 |
| 931 |
| 1,027 |
| 931 |
Materials and supplies |
| 146 |
| 132 |
| 158 |
| 132 |
Deferred income taxes |
| 175 |
| 167 |
| 176 |
| 167 |
Other current assets |
| 64 |
| 163 |
| 52 |
| 163 |
Total current assets |
| 2,910 |
| 2,650 |
| 2,216 |
| 2,650 |
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Investments (Note 2) |
| 1,744 |
| 1,590 |
| 1,779 |
| 1,590 |
Properties less accumulated depreciation |
| 20,886 |
| 20,705 |
| 20,970 |
| 20,705 |
Other assets (Note 9) |
| 1,019 |
| 916 |
| 1,013 |
| 916 |
Total assets | $ | 26,559 | $ | 25,861 | $ | 25,978 | $ | 25,861 |
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Liabilities and stockholders' equity |
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Current liabilities: |
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Accounts payable (Note 9) | $ | 1,115 | $ | 1,163 | $ | 1,168 | $ | 1,163 |
Income and other taxes |
| 315 |
| 231 |
| 272 |
| 231 |
Other current liabilities |
| 223 |
| 213 |
| 265 |
| 213 |
Current maturities of long-term debt |
| 690 |
| 314 |
| 484 |
| 314 |
Total current liabilities |
| 2,343 |
| 1,921 |
| 2,189 |
| 1,921 |
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Long-term debt |
| 6,175 |
| 6,616 |
| 6,141 |
| 6,616 |
Other liabilities (Note 9) |
| 1,497 |
| 1,415 |
| 1,489 |
| 1,415 |
Deferred income taxes |
| 6,593 |
| 6,620 |
| 6,580 |
| 6,620 |
Total liabilities |
| 16,608 |
| 16,572 |
| 16,399 |
| 16,572 |
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Stockholders' equity: |
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Common stock $1.00 per share par value, 1,350,000,000 |
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shares authorized; issued 434,634,158 and |
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shares authorized; issued 417,682,389 and |
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430,718,913 shares, respectively (Note 7) |
| 435 |
| 431 |
| 418 |
| 431 |
Additional paid-in capital |
| 1,275 |
| 992 |
| 1,240 |
| 992 |
Unearned restricted stock (Note 8) |
| - -- |
| (17) |
| - -- |
| (17) |
Accumulated other comprehensive loss (Note 6) |
| (89) |
| (77) |
| (87) |
| (77) |
Retained income (Note 7) |
| 8,350 |
| 7,980 |
| 8,028 |
| 7,980 |
Less treasury stock at cost, 20,813,125 and 20,833,125 shares |
| (20) |
| (20) | ||||
Less treasury stock at cost, 20,790,517 and 20,833,125 |
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shares, respectively |
| (20) |
| (20) | ||||
Total stockholders' equity |
| 9,951 |
| 9,289 |
| 9,579 |
| 9,289 |
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Total liabilities and stockholders' equity | $ | 26,559 | $ | 25,861 | $ | 25,978 | $ | 25,861 |
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See accompanying notes to consolidated financial statements. | See accompanying notes to consolidated financial statements. | See accompanying notes to consolidated financial statements. |
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
(Unaudited)
| Six Months Ended | Nine Months Ended | ||||||
| June 30, | Sept. 30, | ||||||
| 2006 | 2005 | 2006 | 2005 | ||||
| ($ in millions) | ($ in millions) | ||||||
Cash flows from operating activities |
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Net income | $ | 680 | $ | 618 | $ | 1,096 | $ | 919 |
Reconciliation of net income to net cash |
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provided by operating activities: |
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Depreciation |
| 372 |
| 393 |
| 560 |
| 591 |
Deferred income taxes |
| (27) |
| (47) |
| (42) |
| 7 |
Equity in earnings of Conrail |
| (11) |
| (14) |
| (20) |
| (28) |
Gains and losses on properties and investments |
| (32) |
| (20) |
| (40) |
| (26) |
Changes in assets and liabilities affecting operations: |
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Accounts receivable |
| (59) |
| (48) |
| (96) |
| (112) |
Materials and supplies |
| (14) |
| (21) |
| (26) |
| (33) |
Other current assets |
| 60 |
| 76 |
| 84 |
| 106 |
Current liabilities other than debt |
| 93 |
| (79) |
| 146 |
| 93 |
Other – net |
| 36 |
| 2 |
| 55 |
| 85 |
Net cash provided by operating activities |
| 1,098 |
| 860 |
| 1,717 |
| 1,602 |
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Cash flows from investing activities |
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Property additions |
| (579) |
| (357) |
| (862) |
| (578) |
Property sales and other transactions |
| 78 |
| 35 |
| 86 |
| 55 |
Investments, including short-term |
| (1,350) |
| (427) |
| (1,504) |
| (1,232) |
Investment sales and other transactions |
| 877 |
| 364 |
| 1,739 |
| 553 |
Net cash used for investing activities |
| (974) |
| (385) |
| (541) |
| (1,202) |
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Cash flows from financing activities |
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Dividends |
| (133) |
| (88) |
| (207) |
| (141) |
Common stock issued – net |
| 234 |
| 72 |
| 240 |
| 114 |
Purchase and retirement of common stock |
| (186) |
| - -- |
| (916) |
| - -- |
Proceeds from borrowings |
| - -- |
| 332 |
| - -- |
| 332 |
Debt repayments |
| (71) |
| (827) |
| (312) |
| (863) |
Net cash used for financing activities |
| (156) |
| (511) |
| (1,195) |
| (558) |
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Net decrease in cash and cash equivalents |
| (32) |
| (36) |
| (19) |
| (158) |
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Cash and cash equivalents |
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At beginning of year |
| 289 |
| 467 |
| 289 |
| 467 |
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At end of period | $ | 257 | $ | 431 | $ | 270 | $ | 309 |
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Supplemental disclosures of cash flow information | Supplemental disclosures of cash flow information |
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Cash paid during the period for: |
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Interest (net of amounts capitalized) | $ | 234 | $ | 248 | $ | 300 | $ | 330 |
Income taxes (net of refunds) | $ | 221 | $ | 138 | $ | 483 | $ | 161 |
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See accompanying notes to consolidated financial statements. | See accompanying notes to consolidated financial statements. | See accompanying notes to consolidated financial statements. |
NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(Unaudited)
In the opinion of management, the accompanying unaudited interim financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly Norfolk Southern Corporation and subsidiaries' (NS) financial position as of JuneSept. 30, 2006, its results of operations for the three and sixnine months ended JuneSept. 30, 2006 and 2005, and its cash flows for the sixnine months ended JuneSept. 30, 2006 and 2005, in conformity with U.S. generally accepted accounting principles.
These Consolidated Financial Statements should be read in conjunction with the financial statements and notes included in NS’ latest Annual Report on Form 10‑K.
1. Stock Based Compensation
Effective January 1, 2006, NS adopted Statement of Financial Accounting Standards, No. 123(R), “Share-Based Payment,” [SFAS 123(R)]. This statement applies to awards granted, modified, repurchased or cancelled after the effective date as well as awards that are unvested at the effective date and includes, among other things, the requirement to expense the fair value of stock options. The standard also requires that cash settled awards be measured at fair value at each reporting date until ultimate settlement. NS adopted SFAS 123(R) using the modified prospective method, which requires application of the standard to all awards granted, modified, repurchased or cancelled on or after January 1, 2006, and to all awards for which the requisite service has not been rendered as of such date. In accordance with the modified prospective approach, prior period financial statements have not been restated to reflect the impact of SFAS 123(R). As compared to amounts that would have been recognized under APB Opinion No. 25, “Accounting for Stock Issued to Employees” (APB Opinion 25), the adoption of SFAS No. 123(R) resulted in $28$30 million of additional compensation expense for the sixnine months ended JuneSept. 30, 2006, including the immediate expensing of 2006 grants made to retirement-eligible employees, which reduced net income by $20$22 million, or 5 cents per basic and diluted share. Through Dec. 31, 2005, NS applied the intrinsic value recognition and measurement principles of APB Opinion 25 and related interpretations in accounting for its stock-based employee compensation plans (see Note 8).
The following table illustrates the effect on net income and earnings per share if NS had applied the fair value recognition provisions of SFASStatement of Financial Accounting Standards, No. 123, “Accounting for Stock-Based Compensation” to stock-based employee compensation related to all awards:
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| Three Months Ended | Six Months Ended | Three Months Ended | Nine Months Ended | |||||||||
| June 30, | June 30, | Sept. 30, | Sept. 30, | |||||||||
| 2005 | 2005 | 2005 | 2005 | |||||||||
| ($ in millions, except per share) | ($ in millions, except per share) | |||||||||||
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Net income, as reported | $ | 424 |
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| $ | 618 |
| $ | 301 |
| $ | 919 | |
Add: Stock-based employee compensation |
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expense included in reported net income, |
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net of related tax effects |
| 4 |
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| 11 |
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| 19 |
| 30 | |||
Deduct: Stock-based employee compensation |
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expense determined under fair value method, |
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net of related tax effects |
| (4) |
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| (12) |
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| (15) |
| (27) | |||
Pro forma net income | $ | 424 |
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| $ | 617 |
| $ | 305 |
| $ | 922 | |
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Earnings per share: |
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As reported |
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Basic | $ | 1.05 |
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| $ | 1.54 |
| $ | 0.74 |
| $ | 2.28 | |
Diluted | $ | 1.04 |
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| $ | 1.51 |
| $ | 0.73 |
| $ | 2.24 | |
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Pro forma |
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Basic | $ | 1.05 |
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| $ | 1.53 |
| $ | 0.76 |
| $ | 2.29 | |
Diluted | $ | 1.03 |
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| $ | 1.50 |
| $ | 0.74 |
| $ | 2.24 |
2. Investments
| June 30, | Dec. 31, | Sept. 30, | Dec. 31, | ||||
| 2006 | 2005 | 2006 | 2005 | ||||
| ($ in millions) | ($ in millions) | ||||||
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Long-term investments: |
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Investment in Conrail Inc. | $ | 855 | $ | 844 | $ | 864 | $ | 844 |
Other equity method investments |
| 438 |
| 331 |
| 443 |
| 331 |
Company-owned life insurance at net cash surrender value |
| 308 |
| 276 |
| 329 |
| 276 |
Other investments |
| 143 |
| 139 |
| 143 |
| 139 |
Total long-term investments | $ | 1,744 | $ | 1,590 | $ | 1,779 | $ | 1,590 |
Investment in Conrail
Through a limited liability company, Norfolk Southern Corporation ( Norfolk Southern) and CSX Corporation (CSX) jointly own Conrail Inc. (Conrail), whose primary subsidiary is Consolidated Rail Corporation (CRC). NS 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 Norfolk Southern Railway Company (NSR) and CSX Transportation, Inc. (CSXT). The costs of operating the Shared Assets Areas are borne by NSR and CSXT based on usage. In addition, NSR and CSXT pay CRC a fee for access to the Shared Assets Areas. "Conrail rents and services" includes expenses for amounts due to CRC for operation of the Shared Assets Areas. NS’ equity in the earnings of Conrail, net of amortization, is included in “Other income – net.”
“Accounts payable” includes $53$65 million at JuneSept. 30, 2006, and $56 million at Dec. 31, 2005, due to Conrail for the operation of the Shared Assets Areas. In addition, “Other liabilities” include $133 million in long-term advances from Conrail, maturing 2035, entered into in 2005 that bear interest at an average rate of 4.4%.
3. Derivative Financial Instruments
NS useshas 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. NS does not engage in the trading of derivatives. Management has determined that its derivative financial instruments qualify as either fair-value or cash-flow hedges, having values that highly correlate with the underlying hedged exposures, and has designated such instruments as hedging transactions. Credit risk related to the derivative financial instruments is considered to be minimal and is managed by requiring high credit standards for counterparties and periodic settlements.
Diesel Fuel Hedging
In 2001, NS began a program to hedge a portion of its diesel fuel consumption. The intent of the program was 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. No new hedges have been entered into since May 2004, and the last remaining contracts were settled in the second quarter of this year, bringing an end to this program.
The goal of this hedging strategy was to reduce the variability of fuel costs over an extended period of time while minimizing the incremental cost of hedging. The program provided that NS would 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 would be hedged for any month within any 36-month period. After takingta ki ng into account the effect of the hedges, diesel fuel costs represented 15% and 10%12% of NS' operating expenses in the secondthird quarters of 2006 and 2005, respectively.
NS' fuel hedging activity resulted in decreasesno reduction in diesel fuel expenses of $5 millionexpense for the secondthird quarter of 2006, andbut a decrease of $20 million for the first sixnine months, of 2006, compared with $40$41 million and $80$121 million for the same periods, respectively, in 2005. Ineffectiveness, or the extent to which changes in the fair values of the heating oil contracts did not offset changes in the fair values of the expected diesel fuel transactions, was zero in third quarter 2006, compared with a less than a $1 million expense in the second quarter of 2006, compared with a $2 million expense in the secondthird quarter of 2005, and a $1 million expense in the first sixnine months of 2006 compared with a $3 million expense in the same period in 2005.
Interest Rate Hedging
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. NS had $99$90 million or 1%, and $116 million, or 1.7%less than 2%, of its fixed rate debt portfolio, hedged at JuneSept. 30, 2006, and Dec. 31, 2005, respectively, using interest rate swaps that qualify for and are designated as fair-value hedge transactions. NS’ interest rate hedging activity resulted in decreases in interest expenses of less than $1 million and $1 millionin interest expenses for the secondthird quarters of 2006 and 2005, respectively, and $1 million and $2 million for the first sixnine months of 2006 and 2005, respectively.2005. These swaps have been effective in hedging the changes in fair value of the related debt arising from changes in interest rates, and there has been no impact on earnings resulting from ineffectiveness associated with these derivative transactions.
Fair Values
There were no diesel fuel derivative instruments outstanding at JuneSept. 30, 2006. The fair value of NS' diesel fuel derivative instruments at Dec. 31, 2005, was determined based upon current market values as quoted by independent third party dealers. Fair values of interest rate swaps were determined based upon the present value of expected future cash flows discounted at the appropriate implied spot rate from the spot rate yield curve. Fair value adjustments are noncash transactions, and accordingly, are excluded from the Consolidated Statement of Cash Flows. "Accumulated other comprehensive loss," a component of "Stockholders' equity," included unrealized gains of zero and $20 million (pretax) at JuneSept. 30, 2006, and Dec. 31, 2005, respectively, related to the fair value of derivative fuel hedging transactions that will terminate within twelve months of the respective dates. Gains or losses actually realized were based on the fair value of the derivative fuel hedges at the time of termination.
The asset and liability positions of NS' outstanding derivative financial instruments were as follows:
| June 30, | Dec. 31, | Sept. 30, | Dec. 31, | ||||
| 2006 | 2005 | 2006 | 2005 | ||||
| ($ in millions) | ($ in millions) | ||||||
Interest rate hedges |
|
|
|
|
|
|
|
|
Gross fair value asset position | $ | 1 | $ | 3 | $ | 1 | $ | 3 |
Gross fair value (liability) position |
| - -- |
| - -- |
| - -- |
| - -- |
Fuel hedges |
|
|
|
|
|
|
|
|
Gross fair value asset position |
| - -- |
| 20 |
| - -- |
| 20 |
Gross fair value (liability) position |
| - -- |
| - -- |
| - -- |
| - -- |
Total net asset position | $ | 1 | $ | 23 | $ | 1 | $ | 23 |
4. Pensions and Other Postretirement Benefits
Norfolk Southern and certain subsidiaries have both funded and unfunded defined benefit pension plans covering principally salaried employees. Norfolk Southern and certain subsidiaries also provide specified health care and death benefits to eligible retired employees and their dependents. Under the present plans, which may be amended or terminated at NS’ option, a defined percentage of health care expenses is covered, reduced by any deductibles, co-payments, Medicare payments and, in some cases, coverage provided under other group insurance policies.
Pension and Other Postretirement Benefit Cost Components
| Three months ended June 30, | Three months ended Sept. 30, | ||||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | ||||||||
| Pension Benefits | Other Benefits | Pension Benefits | Other Benefits | ||||||||||||
| ($ in millions) | ($ in millions) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Service cost | $ | 6 | $ | 5 | $ | 5 | $ | 4 | $ | 6 | $ | 6 | $ | 5 | $ | 5 |
Interest cost |
| 22 |
| 22 |
| 11 |
| 12 |
| 21 |
| 22 |
| 10 |
| 13 |
Expected return on plan assets |
| (40) |
| (37) |
| (3) |
| (3) |
| (39) |
| (37) |
| (2) |
| (3) |
Amortization of prior service cost (benefit) |
| - -- |
| - -- |
| (2) |
| (3) |
| 1 |
| 1 |
| (2) |
| (2) |
Amortization of unrecognized losses |
| 3 |
| 4 |
| 6 |
| 4 |
| 3 |
| 3 |
| 7 |
| 4 |
Net (benefit) cost | $ | (9) | $ | (6) | $ | 17 | $ | 14 | $ | (8) | $ | (5) | $ | 18 | $ | 17 |
| Six months ended June 30, | Nine months ended Sept. 30, | ||||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | ||||||||
| Pension Benefits | Other Benefits | Pension Benefits | Other Benefits | ||||||||||||
| ($ in millions) | ($ in millions) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Service cost | $ | 15 | $ | 11 | $ | 10 | $ | 8 | $ | 21 | $ | 17 | $ | 15 | $ | 13 |
Interest cost |
| 45 |
| 43 |
| 22 |
| 24 |
| 66 |
| 65 |
| 32 |
| 37 |
Expected return on plan assets |
| (80) |
| (75) |
| (6) |
| (6) |
| (119) |
| (112) |
| (8) |
| (9) |
Amortization of prior service cost (benefit) |
| 1 |
| 1 |
| (4) |
| (6) |
| 2 |
| 2 |
| (6) |
| (8) |
Amortization of unrecognized losses |
| 6 |
| 8 |
| 12 |
| 9 |
| 9 |
| 11 |
| 19 |
| 13 |
Net (benefit) cost | $ | (13) | $ | (12) | $ | 34 | $ | 29 | $ | (21) | $ | (17) | $ | 52 | $ | 46 |
Contributions for Pension and Other Postretirement Benefits
NS previously disclosed in its consolidated financial statements for the year ended Dec. 31, 2005, that it expected to contribute $8 million to its unfunded pension plans and $44 million to its other postretirement (medical and life insurance) benefit plans in 2006. For the sixnine months ended JuneSept. 30, 2006, $4$6 million and $23$33 million of contributions have been made to its unfunded pension plans and its other postretirement benefit plans, respectively. NS presently anticipates contributingthat prior to year end it will contribute an additional $4$2 million to its unfunded pension plans for a total of $8 million and an additional $21$11 million to fund its other postretirement benefit plans in 2006 for a total of $44 million.
5. Earnings Per Share
The following table sets forth the reconciliation of the number of weighted-average shares outstanding used in the calculations of basic and diluted earnings per share:
| Three Months Ended | Six Months Ended | Three Months Ended | Nine Months Ended | ||||||||||||
| June 30, | June 30, | Sept. 30, | Sept. 30, | ||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | ||||||||
| (In millions) | (In millions) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-average shares outstanding |
| 413.5 |
| 403.2 |
| 413.0 |
| 402.5 |
| 402.0 |
| 404.3 |
| 409.3 |
| 403.1 |
Dilutive effect of outstanding options, |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
performance share units and restricted stock |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(as determined by the application of |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
the treasury stock method) |
| 9.3 |
| 6.6 |
| 9.3 |
| 7.4 |
| 7.9 |
| 8.0 |
| 8.8 |
| 7.6 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted weighted-average shares outstanding |
| 422.8 |
| 409.8 |
| 422.3 |
| 409.9 |
| 409.9 |
| 412.3 |
| 418.1 |
| 410.7 |
The calculations exclude options whose exercise price exceeded the average market price of Norfolk Southern Corporation Common Stock (Common Stock) for the period as follows: in 2006, 1 million in the third quarter, none in the second quarter and 1 million in the first quarter; and in 2005, none in the third quarter, 5 million in the second quarter and none in the first quarter. There are no adjustments to "Net income" or “Income from continuing operations” for the diluted earnings per share computations.
6. Comprehensive Income
NS' total comprehensive income was as follows:
| Three Months Ended | Six Months Ended | Three Months Ended | Nine Months Ended | ||||||||||||
| June 30, | June 30, | Sept. 30, | Sept. 30, | ||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | ||||||||
| ($ in millions) | ($ in millions) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income | $ | 375 | $ | 424 | $ | 680 | $ | 618 | $ | 416 | $ | 301 | $ | 1,096 | $ | 919 |
Other comprehensive loss |
| (4) |
| (23) |
| (12) |
| (1) | ||||||||
Other comprehensive income (loss) |
| 2 |
| (8) |
| (10) |
| (9) | ||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total comprehensive income | $ | 371 | $ | 401 | $ | 668 | $ | 617 | $ | 418 | $ | 293 | $ | 1,086 | $ | 910 |
For NS, “Other comprehensive loss"income (loss)" reflects primarily the fair value adjustments, net of tax, to certain derivative financial instruments.instruments and unrealized gains and losses on available-for-sale securities.
7. Stock Purchase Program
In November 2005, NS’ Board of Directors authorized the repurchase of up to 50 million shares of Norfolk Southern Corporation Common Stock (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 facts. 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 increase of long-term debt.
NS has purchased and retired 2.317.1 million shares of its common stock under this program in the secondthird quarter of 2006 at a cost of $120$730 million, of which $111$662 million was charged to retained earnings. For the first sixnine months of 2006, NS purchased and retired 3.620.7 million shares of its common stock under this program at a cost of $186$916 million, of which $173$835 million was charged to retained earnings.
8. Stock-Based Compensation
Under the stockholder-approved Long-Term Incentive Plan (LTIP), a committee of nonemployee directors of the Board of Directors of Norfolk Southern Corporation (Board) or the chief executive officer (if delegated such authority by the committee) may grant stock options, stock appreciation rights (SARs), restricted shares, restricted stock units and performance share units (PSUs), up to a maximum of 88,025,000 shares of Common Stock. Of these shares, 5,000,000 were approved by the Board for issuance to non-officer participants; as a broad-based issuance, stockholder approval was not required. In May 2005, the stockholders approved an amended LTIP which provided that 8,500,000 shares of stock previously approved for issuance under LTIP could be granted as restricted shares, restricted stock unit shares or performance shares. Under the Board-approved Thoroughbred Stock Option Plan (TSOP), the committee may grant stock options up to a maximum of 6,000,000 shares of Common Stock.
The LTIP also permits the payment – on a current or a deferred basis and in cash or in stock – of dividend equivalents on shares of Common Stock covered by options, PSUs or restricted stock units in an amount commensurate with dividends paid on Common Stock. Tax absorption payments also are authorized for any awards under LTIP in amounts estimated to equal the federal and state income taxes applicable to shares of Common Stock issued subject to a share retention agreement.
During the first quarter of 2006, a committee of nonemployee directors of NS’ Board granted stock options, restricted shares, restricted stock units and PSUs pursuant to the LTIP and granted stock options pursuant to the TSOP.
Accounting Method
As disclosed in Note 1, prior to the adoption of SFAS 123(R), NS applied APB Opinion 25 and related interpretations in accounting for awards made under the plans. Accordingly, grants of PSUs, restricted shares, restricted stock units, dividend equivalents, tax absorption payments and SARs resulted in charges to net income, while grants of stock options had no effect on net income. Under SFAS 123(R), all awards will result in charges to net income while dividend equivalents are charged to retained earnings.
Stock-based compensation was a $1 million benefit during the third quarter of 2006, but a cost of $31 million for the same period in 2005. For the first nine months of 2006 and 2005, stock-based compensation costs were $17$100 million and $6$49 million, duringrespectively. The total tax effect recognized in income in relation to stock-based compensation was an expense of $1 million versus a benefit of $11 million for the second quarters ofended Sept. 30, 2006 and 2005, respectively, and $101benefits of $34 million and $18 million for the first six months of 2006 and 2005, respectively. The total tax benefit recognized in income in relation to these compensation costs was $6 million and $2 million for the quarter ended June 30, 2006 and 2005, respectively, and $35 million and $7 million for the first sixnine months of 2006 and 2005, respectively. Compensation expense in 2006 included the immediate recognition of NS’ awards granted to retirement-eligible employees in accordance with SFAS No. 123(R). Under APB Opinion 25 and related interpretations, such awards were amortized over the stated service period.
Stock Options
In the first quarter of 2006, 1,188,700 options were granted under the LTIP and 238,000 options were granted under the TSOP. In each case, the grant price was $49.425, which was the fair market value of Common Stock on the date of grant, and the options have a term of ten years but may not be exercised prior to the first anniversary of the date of grant. Holders of the options granted under LTIP receive cash dividend equivalent payments for five years commensurate with dividends paid on Common Stock.
The fair value of each option award in 2006 was measured on the date of grant using a lattice-based option valuation model. Expected volatilities are based on implied volatilities from traded options on Common Stock and historical volatility of Common Stock. NS uses historical data to estimate option exercises and employee terminations within the valuation model. The average expected option life is derived from the output of the valuation model and represents the period of time that options granted are expected to be outstanding. The average risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. For options granted that include dividend equivalent payments, a dividend yield of zero was used. For purposes of pro forma information required under SFAS 123, the fair value of the option awards in 2005 was determined using the Black-Scholes option-pricing model. The assumptions for both years are shown in the following table:
| 2006 | 2005 |
|
|
|
Expected volatility range | 23.5% - 34.5% | n/a |
Average expected volatility | 27% | 33% |
Average expected option life | 3.7 years | 5 years |
Average risk-free interest rate | 4.5% | 3.7% |
Per-share grant-date fair value | $13.47 | $12.19 |
A summary of options outstanding as of JuneSept. 30, 2006, and changes during the sixnine months then ended is presented below:
|
|
| Weighted |
|
|
| Weighted |
|
|
| Weighted | Average |
|
| Weighted | Average |
|
|
| Average | Remaining | Aggregate |
| Average | Remaining | Aggregate |
| Option | Exercise | Contractual | Intrinsic | Option | Exercise | Contractual | Intrinsic |
| Shares | Price | Life | Value | Shares | Price | Life | Value |
|
|
|
| ($ in millions) |
|
|
| ($ in millions) |
Outstanding at Dec. 31, 2005 | 29,545,680 | $24.35 |
|
| 29,545,680 | $24.35 |
|
|
|
|
|
|
|
|
|
|
|
Granted | 1,427,400 | 49.43 |
|
| 1,427,400 | 49.42 |
|
|
Exercised | (6,931,056) | 24.62 |
|
| (7,118,387) | 24.62 |
|
|
Forfeited | (16,300) | 40.35 |
|
| (16,000) | 40.48 |
|
|
Outstanding at June 30, 2006 | 24,025,724 | $25.75 | 5.3 years | $660 | ||||
Exercisable at June 30, 2006 | 22,605,924 | $24.26 | 5.0 years | $655 | ||||
Outstanding at Sept. 30, 2006 | 23,838,693 | $25.76 | 5.1 years | $ 444 | ||||
Exercisable at Sept. 30, 2006 | 22,418,893 | $24.26 | 4.8 years | $ 444 |
The following table provides information related to options exercised.
| Three Months Ended | Six Months Ended | Three Months Ended | Nine Months Ended | ||||||||||||
| June 30, | June 30 | Sept. 30, | |||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | ||||||||
| ($ in millions) | ($ in millions) | ||||||||||||||
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total intrinsic value | $ | 44 | $ | 3 | $ | 183 | $ | 46 | $ | 4 | $ | 28 | $ | 187 | $ | 74 |
Cash received upon exercise of options | $ | 35 | $ | 6 | $ | 167 | $ | 72 | $ | 3 | $ | 42 | $ | 170 | $ | 114 |
Related tax benefit realized | $ | 16 | $ | - -- | $ | 67 | $ | 15 | $ | 3 | $ | 10 | $ | 70 | $ | 25 |
Prior to the adoption of SFAS 123(R), NS presented tax benefits generated from tax deductions in excess of compensation costs recognized for share-based awards (excess tax benefits) as operating cash flows in the Consolidated Statement of Cash Flows. Beginning in 2006, SFAS 123(R) requires excess tax benefits to be classified as financing cash flows. Accordingly, “Common stock issued – net” in the Consolidated Statement of Cash Flows for the sixnine months ended JuneSept. 30, 2006, included $67$70 million of such tax benefits.
Restricted Shares and Restricted Stock Units
Restricted share and restricted stock unit grants were 664,300 in 2006, with a grant-date fair value of $49.60 and a three-year restriction period, and were 960,400 in 2005, with a grant-date fair value of $34.10 and a five-year restriction period (that may be accelerated to a three-year restriction period for the restricted shares upon achievement of specified performance measures).
A summary of the status of restricted shares and restricted stock units as of JuneSept. 30, 2006, and changes during the sixnine months then ended is presented below:
|
|
| Weighted - Average |
|
| Weighted - Average | ||
|
|
| Grant-Date |
|
| Grant-Date | ||
| Shares | Units | Fair Value | Shares | Units | Fair Value | ||
Nonvested at Dec. 31, 2005 | 1,262,776 |
| 841,852 | $26.80 | 1,262,776 |
| 841,852 | $26.80 |
|
|
|
|
|
|
|
|
|
Granted | 332,150 |
| 332,150 | 49.60 | 332,150 |
| 332,150 | 49.60 |
Vested | (472,422) |
| (314,946) | 20.90 | (473,294) |
| (319,696) | 21.03 |
Forfeited | (2,950) |
| (2,350) | 40.75 | (2,950) |
| (2,350) | 40.75 |
Nonvested at June 30, 2006 | 1,119,554 |
| 856,706 | $36.80 | ||||
Nonvested at Sept. 30, 2006 | 1,118,682 |
| 851,956 | $36.78 |
As of JuneSept. 30, 2006, there was $16$14 million and $18$15 million of total unrecognized compensation related to restricted shares and restricted stock units, respectively. That cost is expected to be recognized over a weighted‑average period of approximately 1.72.0 years. The total fair value of restricted shares vested and restricted stock units paid in cash during the sixnine months ended JuneSept. 30, 2006 and 2005 was $39$40 million and $2 million, respectively.
Performance Share Units
PSUs provide for awards based on achievement of certain predetermined corporate performance goals at the end of a three-year cycle. PSU grants and average grant-date fair values were 1,163,600 and $49.425 in 2006 and 1,344,400 and $34.10 in 2005. One-half of any PSUs earned will be paid in the form of shares of Common Stock with the other half to be paid in cash. Shares earned and issued may be subject to share retention agreements and held by NS for up to five years.
Performance Share Unit Activity
|
| Weighted - Average |
| Weighted - Average | ||
| Performance | Grant-Date | Performance | Grant-Date | ||
| Share Units | Fair Value | Share Units | Fair Value | ||
Balance Dec. 31, 2005 | 3,118,400 | $ | 26.49 | 3,118,400 | $ | 26.49 |
|
|
|
|
|
|
|
Granted | 1,163,600 |
| 49.43 | 1,163,600 |
| 49.43 |
Earned | (345,290) |
| 19.63 | (345,290) |
| 19.63 |
Paid in cash | (345,290) |
| 19.63 | (345,290) |
| 19.63 |
Unearned | (255,420) |
| 19.63 | (255,420) |
| 19.63 |
Forfeited | (24,200) |
| 46.39 | (24,200) |
| 46.39 |
Balance June 30, 2006 | 3,311,800 | $ | 36.41 | |||
Balance Sept. 30, 2006 | 3,311,800 | $ | 36.41 |
As of JuneSept. 30, 2006, there was $50$48 million of total unrecognized compensation related to PSUs granted under the LTIP. That cost is expected to be recognized over a weighted-average period of 1.71.4 years. The total fair value of PSUs earned and paid in cash during the sixnine months ended JuneSept. 30, 2006 and 2005 was $34 million and $18 million, respectively.
9. Commitments and Contingencies
Lawsuits
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 earnings. 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 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 the recorded liability will be reflected in earnings in the periods in which such adjustments are known.
NS was involved in mass tort litigation proceedings arising out of historic flooding events that occurred in West Virginia in 2001. In 2005, one of NS’ subsidiaries was identified as the target defendant for claims related to a specific sub-watershed. During the first quarter, the parties reached a settlement with respect to NS’ liability in the matter. The settlement did not have a material effect on the results of operations in the first quarter.
Casualty Claims
Casualty claims include employee personal injury and occupational claims as well as third-party claims, all exclusive of legal costs. NS engages an independent consulting actuarial firm to aid in valuing its liability for these claims. Job-related accidental injury and occupational claims are subject to the Federal Employers’ Liability Act (FELA), which is applicable only to railroads. FELA’s fault-based system produces results that are unpredictable and inconsistent as compared with a no-fault workers’ compensation system. The variability inherent in this system could result in actual costs being very different from the liability recorded. While the ultimate amount of claims incurred is dependent on future developments, in management’s opinion, the recorded liability is adequate to cover the future payments of claims and is support ed by the most recent actuarial study. In all cases, NS records a liability when the expected loss for the claim is both probable and estimable.
In 2005, NS recorded a liability related to the Jan. 6, 2005 derailment in Graniteville , SC. The liability, which includes a current and long-term portion, 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 reflectsSheets reflect a current and long-term receivable for estimated recoveries from NS’ insurance carriers. TheExpenses in 2005 included $41 million expense recorded in 2005, including $35 million and $2 million in the first and second quarters of 2005, respectively, related to this incident, representsrepresenting 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.
Employee personal injury claims – The largest component of casualties and other claims expense is employee personal injury costs. The actuarial firm engaged by NS provides quarterly studies to aid in valuing its employee personal injury liability and estimating its employee personal injury expense. The actuarial firm studies NS’ historical patterns of reserving for claims and subsequent settlements, takingta ki ng into account relevant outside influences. The actuary uses the results of these analyses to estimate the ultimate amount of the liability, which includes amounts for incurred but unasserted claims. NS adjusts its liability to the actuarially determined amount on a quarterly basis. The estimate of loss liabilities is subject to inherent limitation given the difficulty of predicting future events such as jury decisions, court interpretations or legislative changes and as such the actual loss may vary from the actuarial estimate.
Occupational claims – Occupational claims (including asbestosis and other respiratory diseases, as well as repetitive motion) are often not caused by a specific accident or event but rather result from a claimed exposure over time. Many such claims are being asserted by former or retired employees, some of whom have not been employed in the rail industry for decades. The actuarial firm provides an estimate of the occupational claims liability based upon NS’ history of claim filings, severity, payments and other pertinent facts. The liability is dependent upon management’s judgments made as to the specific case reserves as well as judgments of the consulting actuarial firm in the periodic studies. The actuarial firm’s estimate of ultimate loss includes a provision for those claims that have been incurred but not reported. This provision is derived by analyzing industry data and projecting NS’ experience into the future as far as can be reasonably determined. NS adjusts its liability to the actuarially determined amount on a quarterly basis. However, it is possible that the recorded liability may not be adequate to cover the future payment of claims. Adjustments to the recorded liability are reflected in operating expenses in the periods in which such adjustments become known.
Third-party claims – NS records a liability for third-party claims including those for highway crossing accidents, trespasser and other injuries, automobile liability, property damage and lading damage. The actuarial firm assists with the calculation of potential liability for third-party claims, except lading damage, based upon NS’ experience including number and timing of incidents, amount of payments, settlement rates, number of open claims and legal defenses. The actuarial estimate includes a provision for claims that have been incurred but have not yet been reported. Each quarter NS adjusts its liability to the actuarially determined amount. Given the inherent uncertainty in regard to the ultimate outcome of third-party claims, it is possible that future settlement costs may differ from the estimated liability recorded.
Environmental Matters
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. Claims, if any, against third parties for recovery of cleanup costs incurred by NS are reflected as receivables (when collection is probable) on the balance sheet and are not netted against the associated NS liability. Environmental engineers regularly participate in ongoing evaluations of all known sites and in determining any necessary adjustments to liability estimates. NS also has an Environmental Policy Council, composed of senior managers, to oversee and interpret its environmental policy.
NS' Consolidated Balance Sheets included liabilities for environmental exposures in the amount of $57$55 million at JuneSept. 30, 2006, and $58 million at Dec. 31, 2005 (of which $12 million was accounted for as a current liability at JuneSept. 30, 2006, and Dec. 31, 2005). At JuneSept. 30, 2006, the liability represented NS' estimate of the probable cleanup and remediation costs based on available information at 180175 known locations. On that date, 15 sites accounted for $29 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 180175 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.
The risk of incurring environmental liability – for acts and omissions, past, present and future – is inherent in the railroad business. Some of the commodities in NS' traffic mix, particularly those classified as hazardous materials, can pose special risks that NS and its subsidiaries work diligently to minimize. In addition, several NS subsidiaries own, or have owned, land used as operating property, or which is leased and operated by others, or held for sale. Because environmental problems may exist on these properties that are latent or undisclosed, there can be no assurance that NS will not incur environmental liabilities or costs with respect to one or more of them, the amount and materiality of which cannot be estimated reliably at this time. Moreover, lawsuits and claims involving these and potentially other unidentified environmental sites and matters are likely to arise from time to time. The resulting liabilities could have a significant effect on financial condition, results of operations or liquidity in a particular year or quarter.
However, 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 CorporationNS 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.
On Oct. 19, 2006, the Pennsylvania Department of Environmental Protection (PDEP) commenced proceedings with the Pennsylvania Environmental Hearing Board (EHB) requesting that the EHB impose civil penalties upon NS for alleged violations of state environmental laws and regulations resulting from a discharge of sodium hydroxide that occurred as a result of the derailment of a NS train in Norwich Township, Pennsylvania, on June 30, 2006. The PDEP’s actions seek to impose penalties of $8,890,000 for alleged past violations and $46,420 per day for alleged ongoing violations of state environmental laws and regulations. NS believes that the monetary penalties sought by the PDEP are excessive. Accordingly, NS intends to vigorously defend the action. In addition, NS expects the Pennsylvania Fish and Boat Commission to impose a monetary penalty on NS for damages alleged to have been caused by this accident. NS does not believe that the outcome of these proceedings will have a material effect on its financial condition, results of operations, or liquidity.
Insurance
NS obtains on behalf of itself and its subsidiaries insurance for potential losses for third-party liability and first-party property damages. Specified levels of risk are retained on a self-insurance basis (up to $25 million per occurrence for bodily injury and property damage to third parties and $25 million per occurrence for property owned by NS or in NS’ care, custody or control).
Purchase Commitments
NSR had outstanding purchase commitments of approximately $324$257 million in connection with its 2006 and 2007 capital programs, including 22 locomotives in 2006 and 63 locomotives in 2007. In addition, Norfolk Southern has committed to purchase telecommunications services totaling $12 million through 2007.programs.
Report of Independent Registered Public Accounting Firm
The Stockholders and Board of Directors
Norfolk Southern Corporation:
We have reviewed the accompanying consolidated balance sheet of Norfolk Southern Corporation and subsidiaries as of JuneSeptember 30, 2006, the related consolidated statements of income for the three-month and six-monthnine-month periods ended JuneSeptember 30, 2006 and 2005 and the related consolidated statements of cash flows for the six-monthnine-month periods ended JuneSeptember 30, 2006 and 2005. These consolidated financial statements are the responsibility of the Company’s management.
We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board ( United States ). A review of interim financial information consists principally of applying analytical procedures and makingma ki ng inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board ( United States ), the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.
Based on our reviews, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.
As discussed in note 1 to the consolidated financial statements, effective January 1, 2006, Norfolk Southern Corporation adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment.
We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Norfolk Southern Corporation and subsidiaries as of December 31, 2005, and the related consolidated statements of income, changes in stockholders’ equity and cash flows for the year then ended (not presented herein); and in our report dated February 21, 2006, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2005, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.
/s/ KPMG LLP
Norfolk , Virginia
July 25,October 30, 2006
Item 2. 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
OVERVIEW
NS’ second-quarterthird quarter results reflect a continuation ofsubstantial increases in revenues (up $238 million, or 11%), compared with the trends seen in the first quarter. Revenues increased substantially, notwithstanding the absence of the $55 million benefit from the settlement of two rate cases in the secondthird quarter of 2005. The increase was a result of2005, resulting from higher pricing, including increased fuel surcharges, as well as traffic volume growth. High demand for rail freight transportation continued, which coupled with constrained capacity for other modes of transport and the fluidity of the NS network, enabled NS to continue to raise rates and handle additional volume.was flat. Operating expenses rose $153$51 million, largely because of higher diesel fuel prices and volume-related increases, although casualty expenses also rose.prices. Despite the 10%3% rise in operating expenses, the operating ratio, a measure of the operating revenues consumed by operating expenses, improved 5.4 percentage points to 71.7%70.1%, and income from railway operations rose $85$187 million, or 14%.35%, compared with the third quarter of 2005.
StrongHigher operating resultsincome for the year to date translated into significantly increased cash flows, which, combined with substantial proceeds from employee stock option exercises earlier in the year, were used to fund increased capital expenditures, purchase and retire common stock, fund increased capital expenditures, increase dividends and pay maturing debt and resulted in adebt. At Sept. 30, 2006, the cash and short-term investment balance of $1.5 billion at June 30, 2006. Lookingwas $803 million. Loo ki ng ahead, NS expects revenue increases to moderate, reflecting tempered volume growth to remain consistentand comparison with current levels for the remainder of the year, subject to the effect that prolonged high energy prices and increased interest rates could have on the economy in general.a strong fourth quarter 2005. NS plans to continue its focus on improving service levels and maintaining an aggressive pricing strategy as business is renewed.a market-based approach to pricing.
In the third quarter, NS purchased and retired 17.1 million shares of common stock at a total cost of $730 million under the share repurchase program approved by the Board of Directors on Nov. 22, 2005. Under the program, the Board has authorized the repurchase of up to 50 million shares of NS common stock through the end of 2015. For the first nine months, 20.7 million shares of common stock were been purchased and retired at a total cost of $916 million.
SUMMARIZED RESULTS OF OPERATIONS
Second-quarterThird-quarter net income was $375$416 million in 2006, $49$115 million, belowor 38%, above the $424$301 million for the secondthird quarter of 2005. Results in 2005, included a $96 million increase in net income related to state tax law changes and a $24 million increase related to the settlement of two coal rate cases. The absence of these two items, which together increased 2005 net income by $120 million, was offset in partdriven by higher income from railway operations in 2006.which rose $187 million, or 35% , compared with last year. Railway operating revenues increased $238 million, or 11%, reflecting higher rates, (includingincluding fuel surcharges) as well as increased traffic volumes.surcharges. Railway operating expenses rose $153$51 million, or 10%3%, largely because of increased diesel fuel prices, and to a lesser extent higher volume-related expenses and increased costs for casualties and other claims. Income taxes rose primarily due to the expected phase-out of certain tax credits because of high oil prices, as compared to the second quarter of 2005, which included $16 million more net benefit from such credits.prices.
For the first sixnine months net income was $680$1,096 million in 2006 compared with $618$919 million in 2005. The $62$177 million improvement in net income was driven by highera $420 million increase in income from railway operations, that was offset in part bynotwithstanding the absence of the favorable effects from the$96 million income tax benefit recorded in 2005 because of Ohio tax law changes and the rate case settlements in 2005.changes. Railway operating revenues increased $580$818 million, or 14%13%, reflecting higher rates, (includingincluding fuel surcharges)surcharges, and increased traffic volumes. Railway operating expenses for the first six months rose $347$398 million, or 11%8%, largely because of higher fuel prices, increased compensation and benefit costs higher fuel prices and increased volume-related expenses. As with the quarter, higher income taxes reflected the expected phase-out of certain tax credits.
DETAILED RESULTS OF OPERATIONS
Railway Operating Revenues
Second-quarterThird-quarter railway operating revenues were $2.4 billion in 2006, up $238 million, or 11%, compared with the secondthird quarter of 2005. For the first sixnine months, railway operating revenues were $4.7$7.1 billion in 2006, up $580$818 million, or 14%13%, compared with the first sixnine months of 2005. Revenues for the second quarter and first sixnine months of 2005 included the $55 million of additional coal revenue related to the settlement of thetwo coal rate cases, which, net of associated compensation expenses and income taxes, increased second-quarter 2005 net income by $24 million. cases.
As shown in the following table, the increases were the result of increased average revenues per unit, including fuel surcharges, and higher traffic volume.
| Second Quarter | First Six Months | Third Quarter | First Nine Months |
| 2006 vs. 2005 | 2006 vs. 2005 | 2006 vs. 2005 | 2006 vs. 2005 |
| Increase (Decrease) | Increase (Decrease) | Increase (Decrease) | Increase (Decrease) |
| ($ in millions) | ($ in millions) | ||
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Traffic volume (carloads) | $ 85 | $ 184 | ||
Traffic volume (units) | $ (1) | $ 183 | ||
Revenue per unit/mix | 153 | 396 | 239 | 635 |
Total | $ 238 | $ 580 | $ 238 | $ 818 |
Traffic volume increased 4%was flat in the secondthird quarter, as higher intermodal, metals/construction, and year-to-date,agriculture/consumer products/government volume offset lower automotive and coal shipments. Year-to-date traffic volume increased 3%, principally due to higher intermodal metals/ construction and coalmetals/construction shipments. Revenue per unit increased 7%11% for the secondthird quarter and 9%10% year-to-date notwithstanding the(last year included a $55 million benefit recorded in second quarter 2005 from the settlement of the rate cases in 2005. Approximately 60%cases). About 40% of the remaining revenue per unit increase for the quarter is related to higher fuel surcharges. In the fourth quarter, NS expects the year-over-year increase attributable to fuel surcharges to be lower as oil prices are currently expected to be comparable to those of the fourth quarter of 2005. Fuel surcharge provisions presently cover approximately 90%92% of total revenues. On April 24, 2006, Norfolk SouthernNS announced that it was revising its base rates and applicable fuel surchargessurcharge program for non-intermodal traffic originating and moving on Norfolk Southern-issuedNS-issued tariffs and public quotes issued on or after July 1, 2006. While the mechanics of the new fuel surcharge will beare generally the same as the current fuel surcharge, the trigger price will bewas raised from $23 per barrel of West Texas Intermediate (WTI) Crude Oil to $64 per barrel and the percentage by which the line haul rate is increased when oil exceeds the trigger price will bewas decreased from 0.4% to 0.3% for each dollar or portion thereof in excess of the trigger price. Tariff prices and public quotes have been adjusted to reflect this change. The fuel surcharge is based on the monthly average price of WTI in the second calendar month prior to the month in which the fuel surcharge is applied. The traffic moving under these tariffs and public quotes comprises approximately 6% of Norfolk Southern’sNS’s total revenue base.
Revenues, carloads and average revenue per unit for the commodity groups were as follows:follows (prior period amounts for the chemicals, agriculture/consumer products/government and paper/clay/forest groups have been reclassified to conform to the current year presentation):
| Second Quarter | Third Quarter | |||||||||||||||||||||||
| Revenues | Units | Revenue per Unit | Revenues | Units | Revenue per Unit | |||||||||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | |||||||||||||
| ($ in millions) | (in thousands) | ($ per unit) | ($ in millions) | (in thousands) | ($ per unit) | |||||||||||||||||||
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Coal | $ | 584 | $ | 578 |
| 448.6 |
| 439.3 | $ | 1,304 | $ | 1,314 | $ | 595 | $ | 546 |
| 436.7 |
| 451.8 | $ | 1,362 | $ | 1,209 | |
General merchandise: |
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Automotive |
| 276 |
| 263 |
| 159.8 |
| 164.0 |
| 1,726 |
| 1,603 |
| 211 |
| 229 |
| 119.3 |
| 139.1 |
| 1,774 |
| 1,645 | |
Chemicals |
| 268 |
| 245 |
| 107.6 |
| 116.7 |
| 2,495 |
| 2,104 |
| 286 |
| 254 |
| 109.1 |
| 110.9 |
| 2,612 |
| 2,288 | |
Metals/construction |
| 304 |
| 243 |
| 222.6 |
| 202.4 |
| 1,362 |
| 1,197 |
| 316 |
| 252 |
| 219.1 |
| 206.8 |
| 1,441 |
| 1,222 | |
Agr./consumer prod./govt. |
| 239 |
| 200 |
| 146.1 |
| 147.1 |
| 1,638 |
| 1,365 |
| 239 |
| 198 |
| 147.9 |
| 138.3 |
| 1,617 |
| 1,436 | |
Paper/clay/forest |
| 224 |
| 197 |
| 118.8 |
| 116.4 |
| 1,889 |
| 1,686 |
| 231 |
| 205 |
| 117.6 |
| 118.0 |
| 1,964 |
| 1,732 | |
General merchandise |
| 1,311 |
| 1,148 |
| 754.9 |
| 746.6 |
| 1,737 |
| 1,537 |
| 1,283 |
| 1,138 |
| 713.0 |
| 713.1 |
| 1,799 |
| 1,596 | |
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Intermodal |
| 497 |
| 428 |
| 821.2 |
| 762.0 |
| 605 |
| 562 |
| 515 |
| 471 |
| 841.2 |
| 827.4 |
| 614 |
| 569 | |
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Total | $ | 2,392 | $ | 2,154 |
| 2,024.7 |
| 1,947.9 | $ | 1,182 | $ | 1,106 | $ | 2,393 | $ | 2,155 |
| 1,990.9 |
| 1,992.3 | $ | 1,202 | $ | 1,082 |
| First Six Months | First Nine Months | ||||||||||||||||||||||
| Revenues | Units | Revenue per Unit | Revenues | Units | Revenue per Unit | ||||||||||||||||||
| 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | 2006 | 2005 | ||||||||||||
| ($ in millions) | (in thousands) | ($ per unit) | ($ in millions) | (in thousands) | ($ per unit) | ||||||||||||||||||
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Coal | $ | 1,143 | $ | 1,045 |
| 884.3 |
| 859.9 | $ | 1,293 | $ | 1,215 | $ | 1,738 | $ | 1,591 |
| 1,321.0 |
| 1,311.7 | $ | 1,316 | $ | 1,213 |
General merchandise: |
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Automotive |
| 538 |
| 514 |
| 314.0 |
| 323.2 |
| 1,712 |
| 1,591 |
| 749 |
| 743 |
| 433.3 |
| 462.3 |
| 1,729 |
| 1,607 |
Chemicals |
| 524 |
| 476 |
| 213.0 |
| 228.8 |
| 2,462 |
| 2,081 |
| 813 |
| 733 |
| 324.0 |
| 337.6 |
| 2,508 |
| 2,171 |
Metals/construction |
| 583 |
| 467 |
| 431.2 |
| 388.2 |
| 1,351 |
| 1,202 |
| 899 |
| 719 |
| 650.3 |
| 595.0 |
| 1,382 |
| 1,209 |
Agr./consumer prod./govt. |
| 506 |
| 393 |
| 297.9 |
| 292.6 |
| 1,700 |
| 1,344 |
| 742 |
| 585 |
| 443.9 |
| 426.2 |
| 1,672 |
| 1,373 |
Paper/clay/forest |
| 438 |
| 384 |
| 237.2 |
| 229.8 |
| 1,847 |
| 1,669 |
| 669 |
| 592 |
| 354.8 |
| 354.6 |
| 1,886 |
| 1,668 |
General merchandise |
| 2,589 |
| 2,234 |
| 1,493.3 |
| 1,462.6 |
| 1,734 |
| 1,527 |
| 3,872 |
| 3,372 |
| 2,206.3 |
| 2,175.7 |
| 1,755 |
| 1,550 |
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Intermodal |
| 963 |
| 836 |
| 1,604.3 |
| 1,488.5 |
| 600 |
| 562 |
| 1,478 |
| 1,307 |
| 2,445.5 |
| 2,315.9 |
| 605 |
| 564 |
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Total | $ | 4,695 | $ | 4,115 |
| 3,981.9 |
| 3,811.0 | $ | 1,179 | $ | 1,080 | $ | 7,088 | $ | 6,270 |
| 5,972.8 |
| 5,803.3 | $ | 1,187 | $ | 1,080 |
Coal
Coal revenues increased $6$49 million, or 1%9%, in the secondthird quarter and $98$147 million, or 9%, in the first sixnine months, compared with the same periods last year. Both increases reflected higher rates, including fuel surcharges, and increased traffic volume that were partially offsetwhile the year-to-date increase was tempered by the absence of the $55 million benefit from the coal rate settlements in the second quarter of 2005. Volumes increased 2%declined 3% for the quarter and 3%but increased 1% for the first sixnine months primarily because of increased shipments of utility coal, which rose 6% for both periods, reflecting higher demand in response to the rise in natural gas prices and the replenishment of stockpiles .. Domestic metallurgical coal, coke and iron ore volume increased 3%rose 9% in the secondthird quarter and 5%6% for the first sixnine months due to increased demand for metallurgical coal and coke forfrom the steelsteel-ma ki ng market .. Export coal volume decreased 26%17% in the quarter and 23%22% for the first sixnine months, reflecting weaker EuropeanAsian demand. Utility coal shipments decreased 4% in the third quarter, reflecting lower demand given highfrom NS-served northern utility plants and reduced river traffic. However, utility coal inventory levels andshipments rose 3% for the closure of a coke plant in France , in addition to lower Asian demand.year-to-date. Coal average revenue per carloadunit was down 1%up 13% in the secondthird quarter, reflecting higher fuel surcharges and increased rates, and it increased 8% for the first nine months, as higher fuel surcharges and rates offset the effects of the 2005 coal rate settlements offset higher fuel surchargessettlements.
NS is currently involved in litigation with Virginia Electric and increased rates, but increased 6% forPower Company/Old Dominion Electric Cooperative (Virginia Power) regarding rate adjustment provisions in a transportation contract between them. During the first six months, reflecting higher fuel surchargesthird quarter of 2006, a court order was entered in favor of NS, and rates that overshadowedVirginia Power subsequently filed a notice indicating it intends to appeal. Future developments and the rate case settlements.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 continue to benefit from higher average revenues andper unit as well as increased volumes, reflecting higher utility coal demand, as utilities build up stockpiles, in addition to continued strength in steel production promoting increased metallurgical coal and coke demand.
General Merchandise
General merchandise revenues increased $163$145 million, or 14%13%, in the secondthird quarter and $355$500 million, or 16%15%, in the first sixnine months, compared with the same period last year, a result of higher average revenue per carload and increased traffic volume. Allas all market groups posted higher average revenues per unit for both periods driven by increased rates and fuel surcharges. Traffic volume rose 1%was flat in the secondthird quarter, and 2%but increased 1% for the first sixnine months largely because of improved metals and construction volume that offset declines in the chemicals and automotive groups. Metals and construction volume was up 10%6% for the secondthird quarter and 11%9% for the first sixnine months, principally due to increasedhigher import slab business to NS-served steel mills, more scrap metal shipments, increasedand coil shipments, and for the year-to-date, higher sand, gravel and cement traffic for commercial and public construction projects. Agriculture, consumer products and government volume increased 7% in the third quarter and 4% for the first nine months, reflecting increased ethanol, corn and government shipments. Paper, clay and forest traffic volume increased 2%was flat in the secondthird quarter and 3% for the first sixnine months, driven largely by increasedas higher solid waste and debris traffic that was partially offset by reduced pulp and pulpboard shipments. Chemicals traffic volume declined 8%2% in the secondthird quarter and 7%4% for the first sixnine months, reflecting the closure of several plants on NS lines and reduced chemical plant production. Automotive volumes declined 3%14% in the secondthird quarter and 6% for the first sixnine months due principally to reduced vehicle parts shipments caused byattributable to Ford and General Motors production cuts and plant closures in the U.S., which were partially offset by increased production at Mercedes-Benz and Daimler Chrysler assembly plants served by NS, as well as higher finished vehicle shipments from increased passenger car production at Ford. Agriculture, consumer products and government volume decreased 1% in the second quarter, but increased 2% for the first six months. For the quarter, reduced fertilizer and wheat shipments more than offset increased ethanol, corn and government shipments. The increase in agriculture, consumer products and government for the first six months was driven by increased ethanol, government and corn shipments.
General merchandise revenues for the rest of the year are expected to continue to compare favorablybe comparable with the prior year reflecting continued strength in the global demandlower volumes, primarily for steel, higher average revenues and modestly higher volumes.automotive traffic.
Intermodal
Intermodal revenues increased $69$44 million, or 16%9%, in the secondthird quarter and $127$171 million, or 15%13%, for the first sixnine months, compared with the same period last year, reflecting improved traffic volume,largely because of higher fuel surcharges, increased rates and increased rates.improved traffic volume. Traffic volume rose 8%2% in the secondthird quarter and 6% for the first sixnine months, reflecting strong international and truckload shipments. International traffic volume rose 16%7% in the secondthird quarter and 12% in the first sixnine months, reflecting morehigher imported goods from Asia and exported goods through NS-served East Coast ports, as well as West Coast ports. Domestic truckloadTruckload volume increased 11%3% in the secondthird quarter and 12%9% for the first sixnine months, reflecting the continued growth inexpansion of business with traditional truckload companies. Premium business, grew 1%which includes parcel and LTL carriers, was flat in the secondthird quarter, and 3%but up 2% for the first sixnine months reflecting higher parcel traffic. Triple Crown Services Company volume was flatdown 1% in the secondthird quarter, but grew 3%1% for the first sixnine months, reflecting higher general consumer products traffic. Domestic intermodal marketing companies (IMC) volume decreaseddeclined 11% for the third quarter and 9% for the second quarter and 8% for the first sixnine months, reflecting the continued declinereduction in the transloading of international freight into domestic containers and the reduction of rail industry supplied trailers.containers. Intermodal revenue per unit increased 8% in the secondthird quarter and 7% for the first sixnine months, principally a result of higher fuel surcharges, as well as increased rates and longer-haul international traffic. Thistraffic, which was offset in part by lower volume for higher-rated trailers that reflected the ongoing shift from higher-rated trailersof traffic to lower-rated containers which can be double-stacked.containers.
Intermodal revenues are expected to continue to show modest growth during the fourth quarter of 2006, provided the retail and manufacturing sectors continue to expand despite increased energy costs. expand.
Railway Operating Expenses
Second-quarterThird-quarter railway operating expenses were $1.7 billion in 2006, up $153$51 million, or 10%3%, compared with last year, reflectinglargely because of higher diesel fuel prices, increased volume-related expenses and higher expenses for casualties and other claims.prices. For the first sixnine months, expenses were $3.5$5.1 billion, up $347$398 million, or 11%8%, compared with last year, a result of higher diesel fuel prices, increased compensationscompensation and benefits, and higher volume-related expenses. For the year-to-date, casualties and other claims expenses were unchanged, as derailment expenses in the current year almost equaled last year’s costs related to the January 2005 Graniteville accident.
Compensation and benefits expenses increased $13decreased $5 million, or 2%1%, in the secondthird quarter, and $130but increased $125 million, or 11%7%, in the first sixnine months, compared with the same period last year. The increasesdecrease for the quarter primarily reflected lower stock-based compensation ($32 million) primarily due to the effect of a $9 decline in the per share market price of NS stock in the third quarter this year versus a nearly $10 increase in the stock price in the third quarter of 2005 (every $1 change in the price of NS stock impacts stock-based compensation expense by about $1.5 million). The per share market price of NS stock at the end of the third quarter of 2006 was $44.05 and, therefore, fourth-quarter stock-based compensation expense will increase or decrease by a corresponding $1.5 million for every $1 difference in the year-end price of NS stock. The decrease in the third quarter of 2006 was partially offset by increased salaries and wages ($12 million) and higher costs for activehealth and retiree medicalwelfare benefits ($710 million), increased wage rates ($6 million), more hours for train service employees ($4 million) and increased payroll taxes ($4 million), all of which were partially offset by a $6 million drop in life insurance costs.. The increase for the first sixnine months principally resulted from the implementation of Statement of Financial Accounting Standards No. 123(R) “Share-Based Payment” ($3334 million, including $26$24 million for the accelerated recognition of grants to employees who are retirement eligible), increased stock-based compensation primarily from the rise in NS’ share pricesalaries and wages ($3034 million), higher medical insurance benefitshealth and welfare benefit costs ($1621 million), higher payroll taxes ($15 million), retirement and waiver agreements entered into in the first quarter ($13 million), more payroll taxes ($13 million), increased wage rates ($12 million), the first quarter cost of the regular annual stock-based grant to the former chief executive officer who retired in the first quarter ($11 million) and additional hours for train and engine employees ($1011 million).
Materials, services and rents increased $25$10 million, or 6%2%, in the secondthird quarter and $60$70 million, or 7%5%, for the first sixnine months, compared with last year. Purchased services waswere up $16$7 million for the quarter and $30$37 million for the first sixnine months, primarily reflecting increased intermodal traffic volume. Materials expense wasEquipment rents were up $8$5 million for the quarter and $21$14 million for the first sixnine months. Materials expense was down $2 million for the quarter, but up $19 million for the first nine months reflecting increased maintenance activities, and equipment rents were up $1 million for the quarter and $9 million for the first six months.activities.
Depreciation expense decreased $12$9 million, or 6%5%, for the secondthird quarter and $22$31 million, or 6%5%, for the first sixnine months, compared with the same period last year, reflecting the results of a depreciation study and an analysis of the assets received in the Conrail Corporate Reorganization, both completed in the first quarter. This reduction is expected to continue for the remainder of the year.
Diesel fuel expense increased $98$68 million, or 60%36%, in the secondthird quarter and $179$247 million, or 57%49%, in the first sixnine months, compared with the same periods last year, reflecting higher average prices (up 29% for the quarter and 27% for the first six months), less hedge benefits and higher average prices (up 12% for the quarter and 22% for the first nine months), with consumption (upflat for the quarter and only up 2% in each period).for the year-to-date. Expenses reflected hedging program benefits of $5 millionzero and $20 million in the secondthird quarter and first sixnine months of 2006, compared with benefits of $40$41 million and $80$121 million for the same periods of 2005.2005, respectively. No new hedges have been entered into since May of 2004, and the last remaining contracts settled in the second quarter of this year, bringing an end to the benefits from the program. Legislation enacted in the first quarter of 2005 repealed 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: 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 about 525520 million gallons of diesel fuel per year.
Casualties and other claims expense increased $25decreased $9 million, or 63%15%, in the secondthird quarter and $9 million, or 5%, for the year-to-date, primarily due to increased ladingthe absence of both the $16 million jury verdict in a FELA case and equipment damage associated with derailments and$4 million related to Hurricane Katrina in the third quarter of 2005, partially offset by higher insurance costs.
Other operating expenses decreased $3 million, or 5%, in the third quarter, but were unchanged in the first nine months. The decline for the quarter was principally due to a lesser extent, unfavorable personal injury claims development and higher casualty insurance costs. Forfavorable adjustment on property taxes after the year-to-date, casualties costs were flat as derailment expenses in the current year almost equaled last year’s costs related to the Graniteville accident. finalization of assessment values.
Other Income – Net
Other income – net increased $24$9 million in the secondthird quarter and $57$66 million in the first sixnine months of 2006, compared with the same periods of 2005, principally due to: (1) greater interest income (up $12 million for the third quarter and $35 million for the first nine months) and (2) lower expense associated with tax credit investments (down $18$8 million for the secondthird quarter and $25$33 million for the first sixnine months) primarily due to synthetic fuel related investments — see discussion in the following paragraph and under the heading “Provision for Income Taxes,” below —below. As a result of the share repurchase program (see discussion under the heading “Financial Condition and (2) greaterLiquidity”) and the resulting lower cash balance, interest income (up $13 million foris expected to be lower in the second quarter and $23 million for the first six months). The first six months also reflected more gains on the sale of property and investments (up $12 million).fourth quarter.
NS has membership interests representing ownership in companies that own and operate facilities that produce synthetic fuel from coal. 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 discussion below).
Provision for Income Taxes
The second-quarterthird-quarter effective income tax rate was 36.3%34.6% in 2006, compared with 10.7%31.7% last year. For the first sixnine months, the effective rate was 35.5%35.2% in 2006 compared with 17.8%23.0% in 2005. The 2005 second-quarter and first sixnine months effective ratesrate benefited from a $96 million reduction in deferred taxes resulting from Ohio tax legislation, which lowered last year’s effective ratesrate by 20.2 and 12.88.0 percentage points, respectively.points. The remaining increasesincrease in the effective tax ratesrate for the quarter as well as the remaining increase for the first nine months were largely the result of a reduction in tax credits from synthetic fuel related investments (see below).
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.Internal Revenue Code. The Reference Price for a year is the annual average wellhead price per barrel of unregulated domestic crude oil determined by the Secretary of the Treasury by April 1 of the following year. In 2005, the phase-out range was $53.20 to $66.79, and the phase-out range is adjusted annually for inflation. While NS cannot predict with certainty the Reference Price of a barrel of oil for 2006, based on actual oil prices during the first sixnine months and forward curve prices for the remainder of 2006, in the third quarter NS estimated a 62%36% phase-out of synthetic fuel credits in 2006. As a result, the tax credits in the provision for income taxes were reducedrecorded to reflect this estimate. Likewise, expenses on synthetic fuel related investments, recorded as a component of “Other income-net,income – net,” decreased due toare reflected at the projected phase-out. Both second-quarter
Third-quarter and year-to-date net income reflect a $16$3 million and $19 million, respectively, reduction in net benefits from these credits, as compared with the same periods of 2005, as shown below:
| Three Months Ended | Six Months Ended | ||||||
| June 30, | June 30, | ||||||
| 2006 | 2005 | 2006 | 2005 | ||||
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Effect in “Other income – net:” |
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Expenses on synthetic fuel related investments | $ | 9 | $ | 27 | $ | 23 | $ | 49 |
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Effect in “Provision for income taxes:” |
|
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|
|
|
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Tax benefit of expenses on synthetic fuel |
|
|
|
|
|
|
|
|
related investments |
| 3 |
| 12 |
| 9 |
| 20 |
Tax credits |
| 6 |
| 31 |
| 19 |
| 50 |
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|
|
|
|
|
|
|
|
Total reduction of income tax expense |
| 9 |
| 43 |
| 28 |
| 70 |
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|
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Effect in “Net income:” |
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|
|
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|
|
Net benefit from synthetic fuel related investments | $ | - -- | $ | 16 | $ | 5 | $ | 21 |
Three Months Ended | Nine Months Ended | |||
Sept. 30, | Sept. 30, | |||
2006 | 2005 | 2006 | 2005 | |
($ in millions) |
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Effect in “Other income – net:” |
|
|
|
|
|
|
|
|
Expenses on synthetic fuel related investments | $ | 19 | $ | 26 | $ | 42 | $ | 75 |
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Effect in “Provision for income taxes:” |
|
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|
|
|
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|
Tax benefit of expenses on synthetic fuel |
|
|
|
|
|
|
|
|
related investments |
| 7 |
| 10 |
| 16 |
| 30 |
Tax credits |
| 18 |
| 25 |
| 37 |
| 75 |
|
|
|
|
|
|
|
|
|
Total reduction of income tax expense |
| 25 |
| 35 |
| 53 |
| 105 |
|
|
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Effect in “Net income:” |
|
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Net benefit from synthetic fuel related investments | $ | 6 | $ | 9 | $ | 11 | $ | 30 |
Due to the recenthigh oil price levels, and the prospect for continued high oil prices for the remainder of 2006 as indicated by recent oil futures prices, both of the synthetic fuel partnerships in which NS has investments idled their facilities in July 2006. Accordingly, ifThereafter, oil prices declined and both synthetic fuel partnerships restarted production does not resume, no further tax credits will be generated and no additional expense related to the investments will be incurred; and as a result, NS’ effective tax rate would be about 37% for the last half of the year.in September 2006. Year-to-date net income includes the effects of tax credits generated to date and the associated investment expenses based on an estimated 36% phase-out of synthetic fuel credits for 2006. Because net income for the first half of the year included the effects of tax credits generated through June 30, 2006, and the associated investment expenses based on the previously estimated 62% phase-out of synthetic fuel credits for 2006. In2006 rather than the eventcurrent estimated 36% phase-out, the third quarter net benefit of a 100% phase-out,$6 million includes approximately $9$5 million of net benefits accrued year-to-date ($17 million of pre-tax investment expenses and $26 million of tax benefits, comprised of $7 million tax benefit related to investment expenses and $19 million of tax credits) may have to be reversedproduction in the secondfirst half of 2006.
The Internal Revenue Service (IRS) examination of NS’ consolidated federal income tax returns for the 2002 and 2003 years are being auditedwas completed during the third quarter, and NS expects to appeal certain adjustments proposed by the Internal Revenue Service (IRS).IRS. The IRS examination for these years is expected to be completed in the second half of 2006, and NS does not expect that completionresults of the audit will materially affect netexamination had a negligible effect on the effective tax rate. NS expects the IRS to begin shortly the examination of the consolidated federal income in the quarter of occurrence.tax returns for 2004 and 2005.
Cash provided by operating activities, NS' principal source of liquidity, was $1.1$1.7 billion in the first sixnine months of 2006, compared with $860 million$1.6 billion in the first sixnine months of 2005. The improvement primarily reflected the $233 million increase in income from railway operations.
NS had workingwor ki ng capital of $567$27 million at JuneSept. 30, 2006, compared with $729 million at Dec. 31, 2005.2005, reduced in large part by the amount of share repurchases in the third quarter and higher current maturities of long-term debt. NS’ cash, cash equivalents and short-term investment balances totaled $1.5 billion$803 million at JuneSept. 30, 2006. 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 the remainder of 2006. There have been no material changes to the contractual obligations disclosure contained in NS’ Dec. 31, 2005, Form 10-K.
Cash used for investing activities was $974$541 million in the first sixnine months of 2006, compared with $385 million$1.2 billion in the first sixnine months of 2005. The increasedecrease was the result of higher short-term investment purchases,sales, principally to fund share repurchases reflected in financing activities, offset in part by the $100 million investment in Meridian Speedway LLC (MSLLC) –— see discussion below –— and increased property additions. Capital expenditures for the full year 2006 are expected to be approximately $1.2 billion, and NS expects to make all of its capital expenditures with internally generated funds. For 2007, NS expects to increase capital spending by about 10%.
On May 1, 2006, NS and Kansas City Southern (KCS) formed a joint venture (MSLLC) 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. At the formation of MSLLC , NS contributed $100 million and KCS contributed its 320 mile rail line between Meridian , Mississippi and Shreveport , Louisiana (the Meridian Speedway). NS expects to make an additional contribution in the fourth quarter. NS is recognizing its pro rata share of the joint venture’s earnings or loss as required under the equity method of accounting. NS expects itsNS’ total investment in MSLLC to beis supported by the fair value of the rail line as well as intangible assets obtained through the transaction. 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. This transactionThe joint venture is expected to result in increasedincrease capacity and improvedimprove service on the Meridian Speedway.
During the third quarter, NS and the states of Ohio , West Virginia and Virginia each entered into a Memorandum of Agreement with the Federal Highway Administration that governs the release of up to $95 million in federal funding and up to $11 million in state funding for the Heartland Corridor rail double-stack clearance project. NS expects to spend about $60 million over a five-year period in connection with this project. 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.
Cash used for financing activities was $156 million$1.2 billion in the first sixnine months of 2006, compared with $511$558 million in the first sixnine months of 2005. Financing activities in 2006 included $167 million of proceeds and $67 million of tax benefits from employees’ exercise of stock options (see Note 1 for options outstanding at June 30, 2006). Financing activities in 2006 also included $186$916 million for the purchase and retirement of common stock as part of NS’ ongoing share repurchase program (see Note 7) under which its goal is to reduce shares outstanding to approximately 400 million depending on; the timing and volume of future purchases will be guided by management’s assessment of market conditions and other factors. Financing activities in 2006 also included $170 million of proceeds and $70 million of tax benefits from employees’ exercise of stock options (see Note 1 for options outstanding at Sept. 30, 2006). NS’ debt-to-total capitalization ratio was 40.8%40.9% at JuneSept. 30, 2006, and 42.7% at Dec. 31, 2005.
NS currently has in place and available a $1 billion, five-year credit agreement with three years remaining which provides for borrowing at prevailing rates and includes financial covenants. There were no amounts outstanding under this facility at JuneSept. 30, 2006, 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.
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. There have been no significant changes to the Application of Critical Accounting Estimates disclosure contained in NS’ Form 10‑K as of Dec. 31, 2005.
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 labor agreement changes. The current bargaining round began in late 2004. Industry issues include train crew staffing, contracting out of certain work and employee contributions for health caremedical and other 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 have 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 National Mediation Board, a federal agency, 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 in which casewould delay any strike would be delayed for a further 60 days while the Board made recommendations and the parties 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 was 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. No new hedges have been entered into since May of 2004, and the last remaining contracts were settled in the second quarter of this year, bringing an end to the benefits from the program.
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 JuneSept. 30, 2006, NS' debt subject to interest rate fluctuations totaled $253$245 million. A 1% increase in interest rates would increase NS' total annual interest expense related to all its variable-ratevariable debt by approximately $3$2 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 JuneSept. 30, 2006, the average pay rate under these agreements was 5%6%, and the average receive rate was 7%. The effect of the swaps was to reduce interest expense by less than $1 million in the secondthird quarter and $1 million for the first sixnine months of 2006, compared with reductions of less than $1 million and $2 million for the same periods, respectively, in 2005. 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.
Environmental Matters
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. Claims, if any, against third parties for recovery of cleanup costs incurred by NS are reflected as receivables (when collection is probable) in the Consolidated Balance Sheet and are not netted against the associated NS liability. Environmental engineers regularly participate in ongoing evaluations of all known sites and in determining any necessary adjustments to liability estimates. NS also has an Environmental Policy Council, composed of senior managers, to oversee and interpret its environmental policy.
NS' Consolidated Balance Sheets included liabilities for environmental exposures in the amount of $57$55 million at JuneSept. 30, 2006, and $58 million at Dec. 31, 2005, (of which $12 million was accounted for as a current liability at the end of each period). At JuneSept. 30, 2006, the liability represented NS' estimate of the probable cleanup and remediation costs based on available information at 180175 known locations. On that date, 15 sites accounted for $29 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 180175 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.
Based on an assessment of known facts and circumstances, 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.
On Oct. 19, 2006, the Pennsylvania Department of Environmental Protection (PDEP) filed a complaint for civil penalties and issued an assessment of civil penalties with the Pennsylvania Environmental Hearing Board (EHB) requesting that the EHB impose civil penalties upon NS for alleged violations of state environmental laws and regulations resulting from a discharge of sodium hydroxide which occurred as a result of the derailment of a NS train in Norwich Township, Pennsylvania, on June 30, 2006. The PDEP’s actions seek to impose penalties of $8,890,000 for alleged past violations and $46,420 per day for alleged ongoing violations of state environmental laws and regulations. NS believes that the monetary penalties sought by the PDEP are excessive. Accordingly, NS intends to vigorously defend the action. In addition, NS expects the Pennsylvania Fish and Boat Commission to impose a monetary penalty on NS for damages alleged to have been caused by this accident. NS does not believe that the outcome of these proceedings will have a material effect on its financial condition, results of operations, or liquidity.
New Accounting Pronouncements
In JuneSeptember 2006, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans.” This statement requires an employer to recognize in its statement of financial position the overfunded or underfunded status of defined benefit pension and postretirement plans measured as the difference between the fair value of plan assets and the benefit obligation. Employers must also recognize as a component of other comprehensive income, net of tax, the actuarial gains and losses and the prior service costs, credits and transition costs that arise during the period. NS expects to adopt this statement in the fourth quarter of 2006. Had this statement been effective at Dec. 31, 2005, the estimated impact would have been a reduction of stockholders’ equity of approximately $450 million.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes.” This Interpretation clarifies accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with FASB StatementSFAS No. 109, “Accounting for Income Taxes.” NS expects to adopt this Interpretation in the first quarter of 2007 and is currently evaluating its impact, if any, on NS’ consolidated financial statements.
In December 2004, the Financial Accounting Standards BoardFASB issued Statement of Financial Accounting StandardsSFAS No. 123 (R), “Share-Based Payment.” 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 adopted this standard as required in the first quarter of 2006 (see Note 1).
Inflation
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.
FORWARD-LOOKING STATEMENTS
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: domestic and international economic conditions; interest rates; the business environment in industries that produce and consume rail freight; competition and consolidation within the transportation industry; fluctuation in prices or availability of key materials, in particular diesel fuel; labor difficulties, including strikes and work stoppages; legislative and regulatory developments; changes in securities and capital markets; disruptions to our technology infrastructure, including our computer systems; and natural events such as severe weather, hurricanes and floods. For more discussion about each risk factor, see Part I, Item 1A “Risk Factors” in NS’ Dec. 31, 2005, Form 10-K, and any updates contained herein. Forward-looking statements are not, and should not be relied upon as, a guarantee of future performance or results. Norresults, 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 3. Quantitative and Qualitative Disclosures About Market Risks.
The information required by this item is included in Part I, Item 2, "Management's Discussion and Analysis of Financial ConditionsCondition and Results of Operations" under the heading "Market Risks and Hedging Activities."
Item 4. Controls and Procedures.
(a) Evaluation of Disclosure Controls and Procedures
Norfolk Southern’s Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of NS' disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of JuneSept. 30, 2006. Based on such evaluation, such officers have concluded that, as of JuneSept. 30, 2006, NS' disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to NS (including its consolidated subsidiaries) required to be included in NS' periodic filings under the Exchange Act.
(b) Changes in Internal Control Over Financial Reporting
During the secondthird quarter of 2006, management did not identify any changes in NS' internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, NS’ internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
On Oct. 19, 2006, the Pennsylvania Department of Environmental Protection (PDEP) commenced proceedings with the Pennsylvania Environmental Hearing Board (EHB) requesting that the EHB impose civil penalties upon NS for alleged violations of state environmental laws and regulations resulting from a discharge of sodium hydroxide which occurred as a result of the derailment of a NS train in Norwich Township, Pennsylvania, on June 30, 2006. The PDEP’s actions seek to impose penalties of $8,890,000 for alleged past violations and $46,420 per day for alleged ongoing violations of state environmental laws and regulations. NS believes that the monetary penalties sought by the PDEP are excessive. Accordingly, NS intends to vigorously defend the action. In addition, NS expects the Pennsylvania Fish and Boat Commission to impose a monetary penalty on NS for damages alleged to have been caused by this accident. NS does not believe that the outcome of these proceedings will have a material effect on its financial condition, results of operations, or liquidity.
Item 1A. Risk Factors.
The following risk factors, which were included in NS’ 2005 Form 10-K, are amended in their entirety to read as follows. The remaining risk factors included in NS’ 2005 Form 10-K remain unchanged and are incorporated herein by reference.
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. Legislation proposed in 2006 would require the Department of Homeland Security (DHS) to develop rail security plans and the railroads to submit vulnerability assessments, security plans and employee training programs to DHS for approval. If enacted, such legislation and regulations could impose significant additional costs on railroads. Additionally, regulations adopted by the Department of Transportation and regulations contemplated by the DHS 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.
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 difficultires, 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.
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 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 $25 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.
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, it maintains only limited insurance coverage for first-party property damage and damage to property in NS’ care, custody or control caused by certain acts of terrorism, but not for war.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.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
ISSUER REPURCHASES OF EQUITY SECURITIES
Period | (a) Total Number of Shares (or Units) Purchased | (b) Average Price Paid per Share (or Unit) | (c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs | (d) Maximum Number (or Approximate Dollar Value) of Shares (or Units) that may yet be Purchased Under the Plans or Programs(2) | |
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April 1-30, 2006 | 8,663(1) | $55.78 | 99,605 | 48,590,395 |
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May 1-31, 2006 | 4,733(1) | $55.32 | 1,205,653 | 47,384,742 |
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June 1-30, 2006 | --(1) | $ -- | 995,056 | 46,389,686 |
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Total | 13,396 | $55.62 | 2,300,314 |
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Period | (a) Total Number of Shares (or Units) Purchased | (b) Average Price Paid per Share (or Unit) | (c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs | (d) Maximum Number (or Approximate Dollar Value) of Shares (or Units) that may yet be Purchased Under the Plans or Programs(2) | |
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July 1-31, 2006 | 2,114,283 (1) | $ 44.62 | 2,104,757 | 44,284,929 |
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Aug. 1-31, 2006 | 11,103,593 | $ 42.32 | 11,103,593 | 33,181,336 |
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Sept. 1-30, 2006 | 3,918,274 | $ 42.36 | 3,918,274 | 29,263,062 |
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Total | 17,136,150 | $ 42.61 | 17,126,624 |
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(1) SharesOf this amount, 9,256 represent 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 shares of NS’ common stock may be purchased bythrough Dec. 31, 2015.
Item 4. Submission of Matters to a Vote of Security Holders.
Registrant's Annual Meeting of Stockholders was held on May 11, 2006 , at which meeting three directors were elected to serve for a term of three years and the appointment of the independent registered public accounting firm was ratified.
The three directors were elected by the following vote:
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The appointment of KPMG LLP, independent registered public accounting firm, as auditors of NS’ books and records was ratified by the following vote:
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Item 6. Exhibits.
See Exhibit Index beginning on page 3233 for a description of the exhibits filed as a part of this report.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
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| NORFOLK SOUTHERN CORPORATION | |
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| Registrant | |
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Date: |
| /s/ Dezora M. Martin |
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| Dezora M. Martin | |
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| Corporate Secretary (Signature) | |
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Date: |
| /s/ Marta R. Stewart |
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| Marta R. Stewart | |
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| Vice President and Controller | |
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| (Principal Accounting Officer) (Signature) |
EXHIBIT INDEX
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| Letter regarding unaudited interim financial information.
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* | Rule 13a-14(a)/15d-14(a) Certifications.
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| Section 1350 Certifications.
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* Management contract or compensatory agreement.
** Filed herewith.