AUDITED CONSOLIDATED FINANCIAL STATEMENTS AND SCHEDULE OF CONRAIL INC.
FOR THE YEARS ENDED DEC. 31, 1997, 1996 AND 1995
REPORT OF INDEPENDENT ACCOUNTANTS
The Stockholders and Board of Directors
Conrail Inc.
In our opinion, the accompanying consolidated balance sheets and the
related consolidated statements of income, of stockholders' equity and
of cash flows present fairly, in all material respects, the financial
position of Conrail Inc. and subsidiaries at December 31, 1997 and
1996, and the results of their operations and their cash flows for
each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles. These
financial statements are the responsibility of the Company's
management; our responsibility is to express an opinion on these
financial statements based on our audits. We conducted our audits of
these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the
financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall
financial statement presentation. We believe that our audits provide
a reasonable basis for the opinion expressed above.
Our audits of the consolidated financial statements of Conrail Inc.
and subsidiaries also included an audit of the Financial Statement
Schedule, Schedule II - Valuation and Qualifying Accounts. In our
opinion, the Financial Statement Schedule presents fairly, in all
material respects, the information set forth therein when read in
conjunction with the related consolidated financial statements.
/s/ Price Waterhouse LLP
--------------------
Price Waterhouse LLP
Thirty South Seventeenth Street
Philadelphia, Pennsylvania 19103
January 19, 1998
- 1 -
CONRAIL INC.
CONSOLIDATED STATEMENTS OF INCOME
Years ended December 31,
---------------------------
($ In Millions Except Per Share Data) 1997 1996 1995
------ ------ ------
Revenues $3,765 $3,714 $3,686
------ ------ ------
Operating expenses
Way and structures 458 462 485
Equipment 776 803 766
Transportation 1,388 1,385 1,324
General and administrative 313 312 370
ESOP termination charge (Note 3) 221
Merger-related compensation costs
(Note 3) 222
Merger costs (Note 3) 65 16
Voluntary separation programs (Note 10) 135
Asset disposition charge (Note 11) 285
------ ------ ------
Total operating expenses 3,443 3,113 3,230
------ ------ ------
Income from operations 322 601 456
Interest expense (170) (182) (194)
Other income, net (Note 12) 83 112 130
------ ------ ------
Income before income taxes 235 531 392
Income taxes (Note 7) 228 189 128
------ ------ ------
Net income $ 7 $ 342 $ 264
====== ====== ======
Net income per common share (Note 1)
Basic $ - $ 4.29 $ 3.21
Diluted - 3.91 2.94
Ratio of earnings to fixed charges
(Note 1) 1.98x 3.19x 2.51x
See accompanying notes.
- 2 -
CONRAIL INC.
CONSOLIDATED BALANCE SHEETS
December 31,
----------------
($ In Millions) 1997 1996
------ ------
ASSETS
Current assets
Cash and cash equivalents $ 97 $ 30
Accounts receivable 623 630
Deferred tax assets (Note 7) 115 293
Material and supplies 104 139
Other current assets 15 25
------ ------
Total current assets 954 1,117
Property and equipment, net (Note 4) 6,830 6,590
Other assets 700 695
------ ------
Total assets $8,484 $8,402
====== ======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Short-term borrowings - 99
Current maturities of long-term debt (Note 6) 112 130
Accounts payable 113 135
Wages and employee benefits 366 143
Casualty reserves 141 141
Accrued and other current liabilities (Note 5) 476 444
------ ------
Total current liabilities 1,208 1,092
Long-term debt (Note 6) 1,732 1,876
Casualty reserves 198 190
Deferred income taxes (Note 7) 1,453 1,478
Special income tax obligation (Note 7) 283 346
Other liabilities 445 313
------ ------
Total liabilities 5,319 5,295
------ ------
Commitments and contingencies (Note 13)
Stockholders' equity (Notes 2, 3 and 9)
Preferred stock (no par value; 15,000,000
shares authorized; no shares issued)
Series A ESOP convertible junior preferred
stock (no par value; 10,000,000 shares
authorized; 0 and 7,303,920 shares
issued and outstanding, respectively) - 211
Unearned ESOP compensation (155) (222)
Common stock ($1 par value; 250,000,000
shares authorized; 6,320,349 and 87,768,428
shares issued, respectively; 100 and
82,244,973 shares outstanding, respectively) 6 88
Additional paid-in capital 3,006 2,404
Employee benefits trust (0 and
3,394,988 shares, respectively) (274) (384)
Retained earnings 1,324 1,357
------ ------
3,907 3,454
Treasury stock, at cost (742) (347)
------ ------
Total stockholders' equity 3,165 3,107
------ ------
Total liabilities and stockholders' equity $8,484 $8,402
====== ======
See accompanying notes.
- 3 -
CONRAIL INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Series A Unearned Additional Employee
Preferred ESOP Common Paid-in Benefits Retained Treasury
($ In Millions Except Per Share Data) Stock Compensation Stock Capital Trust Earnings Stock
--------- ------------ ------ ---------- -------- -------- --------
Balance, January 1, 1995 $ 283 $(243) $80 $1,848 $1,056 $ (99)
Amortization 10
Net income 264
Common dividends, $1.60 per share (129)
Preferred dividends, $2.165 per share (21)
Common shares acquired (92)
Exercise of stock options 6
Establishment of employee benefits trust 5 245 $(250)
Employee benefits trust transactions, net 84 (79)
Other (1) 4 6
----- ----- --- ------ ----- ------ -----
Balance, December 31, 1995 282 (233) 85 2,187 (329) 1,176 (191)
Amortization 11
Net income 342
Common dividends, $1.80 per share (146)
Preferred dividends, $2.165 per share (20)
Common shares acquired (156)
Exercise of stock options 29 53
Employee benefits trust transactions, net 128 (116)
Effects of voluntary separation programs (8) 8
Effects of CSX tender offer (63) 3 60
Other 5
----- ---- --- ------ ----- ------ -----
Balance, December 31, 1996 211 (222) 88 2,404 (384) 1,357 (347)
Amortization 2
Net income 7
Common dividends, $.475 per share (40)
Preferred dividends, $.541 per share (3)
Exercise of stock options 2 11
Employee benefits trust transactions, net (5) 9
Effects of Conrail acquisition, net
(Notes 2 and 3) (209) (82) 594 90 (393)
Allocation of unearned ESOP compensation 65
Other (2) 11 3 (2)
----- ----- --- ------ ----- ------ -----
Balance, December 31, 1997 $ - $(155) $ 6 $3,006 $(274) $1,324 $(742)
===== ===== === ====== ===== ====== =====
See accompanying notes.
- 4 -
CONRAIL INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years ended December 31,
------------------------
($ In Millions) 1997 1996 1995
----- ----- -----
Cash flows from operating activities
Net income $ 7 $ 342 $ 264
Adjustments to reconcile net income to
net cash provided by operating activities:
ESOP termination charge 221
Merger-related compensation costs 159
Voluntary separation programs 135
Asset disposition charge 285
Depreciation and amortization 293 283 293
Deferred income taxes 152 183 108
Special income tax obligation (63) (94) (73)
Gains from sales of property (23) (24) (27)
Pension credit (61) (46) (43)
Changes in:
Accounts receivable 7 (16) 32
Accounts and wages payable 42 (18) 8
Deferred tax assets 178 40 (84)
Settlement of tax audit 6 (39)
Other (34) (77) 10
----- ----- -----
Net cash provided by operating
activities 884 669 773
----- ----- -----
Cash flows from investing activities
Property and equipment acquisitions (439) (387) (415)
Proceeds from disposals of properties 25 34 38
Other (31) (46) (59)
----- ----- -----
Net cash used in investing activities (445) (399) (436)
----- ----- -----
Cash flows from financing activities
Repurchase of common stock (156) (92)
Net proceeds from (repayments of)
short-term borrowings (99) 10 (23)
Proceeds from long-term debt 26 85
Payment of long-term debt (238) (184) (134)
Loans from and redemptions of
insurance policies 95
Dividends on common stock (40) (146) (129)
Dividends on Series A preferred stock (3) (25) (21)
Proceeds from stock options and other 8 67 7
----- ----- -----
Net cash used in financing
activities (372) (313) (307)
----- ----- -----
Increase(decrease) in cash and cash equivalents 67 (43) 30
Cash and cash equivalents
Beginning of year 30 73 43
----- ----- -----
End of year $ 97 $ 30 $ 73
===== ===== =====
See accompanying notes.
- 5 -
CONRAIL INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
------------------------------------------
Industry
--------
Conrail Inc. ("Conrail") is a holding company of which the
principal subsidiary is Consolidated Rail Corporation ("CRC"), a
freight railroad which operates within the northeast and midwest
United States and the Province of Quebec. Conrail has been
acquired by CSX Corporation ("CSX") and Norfolk Southern
Corporation ("NSC"), however, the transaction is pending the
approval of the Surface Transportation Board ("STB") (Notes 2 and
3).
Principles of Consolidation
---------------------------
The consolidated financial statements include Conrail and
majority-owned subsidiaries. Investments in 20% to 50% owned
companies are accounted for by the equity method.
Cash Equivalents
----------------
Cash equivalents consist of commercial paper, certificates of
deposit and other liquid securities purchased with a maturity of
three months or less, and are stated at cost which approximates
market value.
Material and Supplies
---------------------
Material and supplies consist mainly of fuel oil and items for
maintenance of property and equipment, and are valued at the
lower of cost, principally weighted average, or market.
Property and Equipment
----------------------
Property and equipment are recorded at cost. Depreciation is
provided using the composite straight-line method. The cost (net
of salvage) of depreciable property retired or replaced in the
ordinary course of business is charged to accumulated
depreciation and no gain or loss is recognized.
Asset Impairment
----------------
Long-lived assets are reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an
asset may not be recoverable. Expected future cash flows from
the use and disposition of long-lived assets are compared to the
current carrying amounts to determine the potential impairment
loss.
Revenue Recognition
-------------------
Revenue is recognized proportionally as a shipment moves on the
Conrail system from origin to destination.
- 6 -
Earnings Per Share
------------------
Earnings per share are not presented for 1997 as a result of the
acquisition of the Company's common stock which was completed on
May 23, 1997 (Notes 2 and 3). Following that acquisition, the
Company's common stock was delisted from the New York Stock
Exchange and deregistered with the Securities and Exchange
Commission.
The Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 128,
"Earnings per Share" (SFAS 128) to be effective for periods
ending after December 15, 1997. SFAS 128 requires all prior-
period earnings per share data presented to be restated to
conform with the provisions of this pronouncement. SFAS 128
replaces primary earnings per share with the presentation of
basic earnings per share and fully diluted earnings per share
with diluted earnings per share. The earnings per share amounts
resulting from the application of SFAS 128 are not materially
different than those previously presented by the Company for
1996 and 1995.
For 1996 and 1995, basic earnings per share are based on net
income adjusted for the effects of preferred dividends net of
income tax benefits, divided by the weighted average number of
shares outstanding during the period. Diluted earnings per
share assume conversion of Series A ESOP Convertible Junior
Preferred Stock ("ESOP Stock") to Conrail common stock and the
dilutive effects of stock options. Net income amounts
applicable to diluted earnings per share have been adjusted by
the increase, net of income tax benefits, in ESOP-related
expenses assuming conversion of all ESOP Stock to common stock.
Shares in the Conrail Employee Benefits Trust are not considered
outstanding for computing earnings per share. The weighted
average number of shares of common stock outstanding during each
of the two years ended December 31, 1996 are as follows:
1996 1995
---------- ----------
Basic weighted
average shares 76,903,665 78,144,694
Diluted weighted
average shares 87,022,413 88,533,558
Ratio of Earnings to Fixed Charges
----------------------------------
Earnings used in computing the ratio of earnings to fixed charges
represent income before income taxes plus fixed charges, less
equity in undistributed earnings of 20% to 50% owned companies.
Fixed charges represent interest expense together with interest
capitalized and a portion of rent under long-term operating
leases representative of an interest factor.
- 7 -
New Accounting Standards
------------------------
During 1997, the FASB issued SFAS No. 130, "Reporting
Comprehensive Income" and SFAS No. 131, "Disclosures about
Segments of an Enterprise and Related Information". The Company
has determined that adoption of these statements will not impact
its consolidated financial position, results of operations or
cash flows. Both pronouncements are effective for fiscal years
beginning after December 15, 1997.
Use of Estimates
----------------
The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts
of assets and liabilities and 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. Actual results could differ from those estimates.
Reclassification of Prior-Year Data
-----------------------------------
Certain amounts have been reclassified in the consolidated
financial statements to conform to the current year presentation.
2. Acquisition of Conrail Inc.
--------------------------
On April 8, 1997, Conrail and CSX entered into the Fourth
Amendment (the "Fourth Amendment") to the Agreement and Plan of
Merger (as amended through the Fourth Amendment, the "Merger
Agreement") which facilitated CSX and NSC entering into an
agreement with respect to their joint acquisition of Conrail as
contemplated by the Third Amendment to the Merger Agreement,
dated as of March 7, 1997. The terms of the CSX-NSC Agreement
are embodied in a letter agreement dated as of April 8, 1997
(the "CSX/NSC Letter Agreement") and the Transaction Agreement
dated as of June 10, 1997 among Conrail, CSX and NSC.
The CSX/NSC Letter Agreement provided, among other things, (i)
for the termination of the NSC's outstanding offer to purchase
Conrail shares and the dismissal of litigation between CSX and
NSC, (ii) that Conrail would, after the effective time of its
merger into a wholly-owned subsidiary of CSX, become a direct
or indirect jointly-owned subsidiary of CSX and NSC, (iii) that
CSX and NSC would jointly acquire, for $115 in cash, all
Conrail shares not already owned by CSX and NSC through a
tender offer that closed on May 23, 1997 and subsequent merger,
and (iv) that Conrail would continue to be managed by its
existing Board of Directors until the requisite approval of the
STB is obtained, at which time CSX and NSC will be separately
allocated certain of Conrail's railroad assets and will jointly
operate certain other railroad activities of Conrail.
The Fourth Amendment also provided that, following April 8,
1997, Conrail's Board of Directors would not declare, and
- 8 -
Conrail would not pay, any dividend on Conrail's capital stock
with a record date on or prior to May 30, 1997.
On May 23, 1997, the CSX-NSC joint tender offer for the remaining
outstanding shares of Conrail's common and ESOP Stock was
concluded, with 53.4 million shares having been tendered. On June
2, 1997, Conrail became the surviving corporation in a merger with
Green Acquisition Corp., a jointly-owned, indirect subsidiary of
CSX and NSC, as a result of which the remaining outstanding
capital stock of Conrail was acquired by NSC and CSX.
Simultaneous with the merger, Conrail's common stock was delisted
from the New York Stock Exchange and, through the filing of a Form
15, deregistered with the Securities and Exchange Commission. The
Conrail stock acquired by NSC and CSX is being held in a voting
trust pending approval of the joint acquisition by the STB, which
is expected to occur in the third quarter of 1998.
In the course of normal business, the Company interchanges freight
with both NSC and CSX for transport to destinations both within
and outside of Conrail's service region. The Company shares
ownership interests with either one or both railroads in various
transportation-related entities, all of which are immaterial to
the Company's operating results and financial position.
3. Merger-Related Costs
--------------------
In connection with its joint acquisition by NSC and CSX, the
Company has incurred pre-tax merger-related costs totaling $65
million ($41 million after income taxes) during 1997. Merger
costs of $16 million ($10 million after income taxes) were
incurred during 1996 related to the previously proposed merger of
Conrail with CSX. Merger costs incurred during both years are
composed primarily of fees for investment banking, legal and
consulting services.
In the second quarter of 1997, the Company recorded a charge of
$221 million (no related income tax effect) for the termination
of its Non-union Employee Stock Ownership Plan ("ESOP") as a
result of the repayment of the ESOP note payable of $291 million
and related accrued interest to the Company. The Company had
recorded a long-term liability of $221 million related to the
ESOP termination charge, which is not expected to require future
use of the Company's cash for settlement. Such liability is
being reduced as the cash proceeds, which the ESOP currently
holds as a result of selling its ESOP Stock in the joint tender
offer, are allocated to eligible ESOP participants.
During the second quarter of 1997, the Company recorded a charge
of $110 million ($103 million after income taxes) in connection
with employment agreements with certain executives, which became
operative upon a change in control as defined in such
agreements. The agreement with CSX permits Conrail to enter
into new agreements with executives to pay some or all of these
benefits upon the earlier of the STB's approval or disapproval
- 9 -
of the transaction or May 31, 1998, if the executives are
employed on that date. Severance benefits to be paid to other
Company employees will be determined and accrued when the
employees adversely affected by the transaction are identified,
which is expected to occur near the time of the STB decision.
During 1997, the Company recorded cumulative charges totaling
$49 million ($31 million after income taxes) representing a
portion of an amount to be paid to certain non-union employees
as an incentive to continue their employment with the Company
through the effective date of the requisite STB approval of the
transaction and subsequent transition period. The total amount
of these incentive payments is expected to be approximately $125
million and will continue to be accrued ratably through the
fourth quarter of 1998. The Company has recorded a short-term
liability of $159 million included in "wages and employee
benefits" on the 1997 balance sheet related to the above-
mentioned merger-related compensation costs through December 31,
1997, however, such liability is not expected to require future
use of the Company's cash for settlement as funding is expected
from other sources, including the Employee Benefits Trust.
Also, as a result of the acquisition of Conrail, all outstanding
performance shares and all outstanding unvested stock options,
restricted shares and phantom shares vested during the second
quarter of 1997. The Company paid all of the amounts due
employees under these arrangements and recorded a $63 million
charge ($39 million after income taxes).
4. Property and Equipment
----------------------
December 31,
-----------------
1997 1996
------- -------
(In Millions)
Roadway $ 7,167 $ 7,021
Equipment 1,398 1,231
Less: Accumulated depreciation (1,736) (1,654)
Allowance for disposition (392) (408)
------- -------
6,437 6,190
------- -------
Capital leases (primarily equipment) 869 908
Accumulated amortization (476) (508)
------- -------
393 400
------- -------
$ 6,830 $ 6,590
======= =======
Conrail acquired equipment and incurred related long-term debt
under various capital leases of $79 million in 1997, $82 million
in 1996 and $71 million in 1995. In 1995 (Note 11) and 1991, the
Company recorded allowances for disposition for the sale or
abandonment of certain under-utilized rail lines and other
facilities.
- 10 -
5. Accrued and Other Current Liabilities
-------------------------------------
December 31,
-----------------
1997 1996
---- ----
(In Millions)
Freight settlements due others $ 43 $ 48
Equipment rents (primarily car hire) 74 74
Unearned freight revenue 77 79
Property and corporate taxes 55 49
Other 227 194
---- ----
$476 $444
==== ====
6. Long-Term Debt
--------------
Long-term debt outstanding, including the weighted average
interest rates at December 31, 1997, is composed of the
following:
December 31,
------------------
1997 1996
------ ------
(In Millions)
Capital leases $ 465 $ 491
Medium-term notes payable,
7.50%, due 1998 to 1999 60 109
Notes payable, 9.75%, due 2000 250 250
Debentures payable, 7.88%, due 2043 250 250
Debentures payable, 9.75%, due 2020 544 544
Equipment and other obligations, 6.66% 275 262
Commercial paper - 100
------ ------
1,844 2,006
Less current portion (112) (130)
------ ------
$1,732 $1,876
====== ======
Using current market prices when available, or a valuation based
on the yield to maturity of comparable debt instruments having
similar characteristics, credit rating and maturity, the total
fair value of the Company's long-term debt, including the current
portion, but excluding capital leases, is $1,607 million and
$1,685 million at December 31, 1997 and 1996, respectively,
compared with carrying values of $1,379 million and $1,515
million at December 31, 1997 and 1996, respectively.
The Company's noncancelable long-term leases generally include
options to purchase at fair value and to extend the terms.
Capital leases have been discounted at rates ranging from 3.09%
to 14.26% and are collateralized by assets with a net book value
of $393 million at December 31, 1997.
- 11 -
Minimum commitments, exclusive of executory costs borne by the
Company, are:
Capital Operating
Leases Leases
------- ---------
(In Millions)
1998 $ 107 $119
1999 99 94
2000 76 83
2001 60 74
2002 57 68
2003 - 2017 239 476
----- ----
Total 638 $914
====
Less interest portion (173)
-----
Present value $ 465
=====
Operating lease rent expense was $122 million in 1997, $127
million in 1996 and $130 million in 1995.
In June 1993, the Company and CRC filed a shelf registration
statement on Form S-3 to enable CRC to issue up to $500 million in
debt securities or the Company to issue up to $500 million in
convertible debt and equity securities. The remaining balance
under this shelf registration was $312 million at December 31,
1997, although restrictions arising from the Company's acquisition
may prevent its use.
In January 1997, CRC assumed $31 million of Equipment Trust
Certificates, at an interest rate of 8.31%, due 2012, to finance
the lease buyout of 20 locomotives from Locomotive Management
Services, a general partnership of which the Company holds a fifty
percent interest.
Equipment and other obligations mature in 1998 through 2043 and
are collateralized by assets with a net book value of $266 million
at December 31, 1997. Maturities of long-term debt other than
capital leases are $48 million in 1998, $48 million in 1999, $268
million in 2000, $19 million in 2001, $18 million in 2002 and $978
million in total from 2003 through 2043.
During 1997, CRC repaid all of its commercial paper, and no
commercial paper remains outstanding at December 31, 1997.
CRC maintains a $440 million uncollateralized bank credit agree-
ment with a group of banks which is used for general corporate
purposes and to support CRC's commercial paper program. The
agreement matures in 2000 and requires interest to be paid on
amounts borrowed at rates based on various defined short-term
rates and an annual maximum fee of .110% of the facility amounts.
- 12 -
The agreement contains, among other conditions, restrictive
covenants relating to a debt ratio and consolidated tangible net
worth. During 1997, CRC had no borrowings under this agreement.
Interest payments were $163 million in 1997, $170 million in 1996
and $177 million in 1995.
7. Income Taxes
------------
The provisions for income taxes are composed of the following:
1997 1996 1995
---- ---- -----
(In Millions)
Current
Federal $122 $ 90 $ 78
State 17 10 15
---- ---- ----
139 100 93
---- ---- ----
Deferred
Federal 115 151 110
State 37 32 (2)
---- ---- ----
152 183 108
---- ---- ----
Special income tax obligation
Federal (54) (80) (61)
State (9) (14) (12)
---- ---- ----
(63) (94) (73)
---- ---- ----
$228 $189 $128
==== ==== ====
In conjunction with the public sale in 1987 of the 85% of the
Company's common stock then owned by the U.S. Government, federal
legislation was enacted which resulted in a reduction of the tax
basis of certain of the Company's assets, particularly property
and equipment, thereby substantially decreasing tax depreciation
deductions and increasing future federal income tax payments.
Also, net operating loss and investment tax credit carryforwards
were canceled. As a result of the sale-related transactions, a
special income tax obligation was recorded in 1987 based on an
estimated effective federal and state income tax rate of 37.0%.
The nondeductibility of the ESOP termination charge and certain
merger-related compensation costs for federal and state income
tax purposes, has resulted in a significant difference between
the Company's statutory and effective tax rates for 1997 (Note
3).
- 13 -
A tax law was enacted during the third quarter of 1997 by a state
in which CRC operates which changed the Company's method of
computing taxes and resulted in a tax rate increase. Income tax
expense for 1997 was increased by $22 million representing the
effects of adjusting deferred income taxes and the special income
tax obligation for the rate increase as required by SFAS 109,
"Accounting for Income Taxes" ("SFAS 109").
As a result of a decrease in a state income tax rate enacted
during 1995, income tax expense for that year was reduced by $21
million representing the effects of adjusting deferred income
taxes and the special income tax obligation for the rate decrease
as required by SFAS 109.
Reconciliations of the U.S. statutory tax rates with the
effective tax rates are as follows:
1997 1996 1995
---- ---- ----
Statutory tax rate 35.0% 35.0% 35.0%
State income taxes,
net of federal benefit 3.2 3.4 3.5
ESOP termination charge 36.3
Nondeductible merger-related
compensation costs 14.9
Effect of state tax increase
(decrease) on deferred taxes 9.3 (5.3)
Other (1.7) (2.8) (.5)
---- ---- ----
Effective tax rate 97.0% 35.6% 32.7%
==== ==== ====
In 1996, the Company reached a settlement with the Internal
Revenue Service ("IRS") related to the audit of the Company's
consolidated federal income tax returns for the fiscal years 1990
through 1992. The Company made a payment of $39 million pending
resolution of the final interest determination related to the
settlement, of which $6 million was refunded to the Company in
1997. The Company's consolidated federal income tax returns for
fiscal years 1993 through 1995 are currently being examined by
the IRS. Federal and state income tax payments were $120 million
in 1997, $145 million in 1996 (excluding tax settlement) and $109
million in 1995.
- 14 -
Significant components of the Company's special income tax
obligation and deferred income tax liabilities (assets) are as
follows:
December 31,
-----------------
1997 1996
------ ------
(In Millions)
Current assets $ (10) $ (9)
Current liabilities (97) (245)
Miscellaneous (8) (39)
------ ------
Current deferred tax asset, net $ (115) $ (293)
====== ======
Noncurrent liabilities:
Property and equipment 1,877 1,939
Other long-term assets (primarily prepaid
pension asset) 90 92
Miscellaneous 130 98
------ ------
2,097 2,129
------ ------
Noncurrent assets:
Nondeductible reserves and other
liabilities (200) (174)
Tax benefit transfer receivable (36) (36)
Miscellaneous (125) (95)
------ ------
(361) (305)
------ ------
Special income tax obligation and
deferred income tax liabilities, net $1,736 $1,824
====== ======
8. Employee Benefits
-----------------
Pension Plans
-------------
The Company and certain subsidiaries maintain defined benefit
pension plans which are noncontributory for all non-union
employees and generally contributory for participating union
employees. Benefits are based primarily on credited years of
service and the level of compensation near retirement. Funding
is based on the minimum amount required by the Employee
Retirement Income Security Act of 1974.
- 15 -
Pension credits include the following components:
1997 1996 1995
----- ---- ----
(In Millions)
Service cost - benefits earned during the period $ 8 $ 9 $ 8
Interest cost on projected benefit obligation 50 51 51
Return on plan assets - actual (197) (138) (254)
- deferred 99 47 167
Net amortization and deferral (21) (15) (15)
----- ---- ----
$ (61) $(46) $(43)
===== ==== ====
The funded status of the pension plans and the amounts
reflected in the balance sheets are as follows:
1997 1996
------ -----
(In Millions)
Accumulated benefit obligation ($605 million
and $655 million vested, respectively) $ 610 $ 661
====== ======
Market value of plan assets 1,308 1,187
Projected benefit obligation (699) (734)
------ ------
Plan assets in excess of projected
benefit obligation 609 453
Unrecognized prior service cost 33 36
Unrecognized transition net asset (72) (90)
Unrecognized net gain (343) (231)
------ ------
Net prepaid pension cost $ 227 $ 168
====== ======
The assumed weighted average discount rates used in 1997 and 1996
are 7.0% and 7.5%, respectively, and the rate of increase in
future compensation levels used in determining the actuarial
present value of the projected benefit obligation as of
December 31, 1997 and 1996 is 6.0%. The expected long-term rate
of return on plan assets (primarily equity securities) in 1997
and 1996 is 9.0%.
Savings Plans
-------------
The Company and certain subsidiaries provide 401(k) savings plans
for union and non-union employees. However, in connection with
the close of the CSX-NSC joint tender offer for Conrail, the
Company's Non-union ESOP was terminated with the repayment of the
ESOP note payable of $291 million and related accrued interest in
the second quarter of 1997, resulting in a charge of $221 million
(no related income tax effect) (Notes 2 and 3). Under the Non-
union ESOP, 100% of employee contributions were matched in the
form of ESOP Stock for the first 6% of a participating employee's
base pay. There is no Company match provision under the union
employee plan except for three unions which negotiated a Company
- 16 -
match as part of their new contract provisions. Savings plan
expense was $1 million in 1997 and $4 million in 1996 and 1995.
In connection with the formation of the Non-union ESOP in
1990, the Company issued 9,979,562 of the authorized 10 million
shares of its ESOP Stock to the Non-union ESOP in exchange for a
20 year promissory note from the Non-union ESOP in the principal
amount of approximately $290 million. In addition, unearned ESOP
compensation in the same amount was recognized as a charge to
stockholders' equity coincident with the Non-union ESOP's
issuance of its promissory note to the Company. The debt of the
Non-union ESOP was recorded by the Company and offset against the
promissory note from the Non-union ESOP. The Company received
debt service payments from the Non-union ESOP of $11 million in
1997, $40 million in 1996 and $31 million in 1995.
Prior to the close of the joint tender offer (Notes 2 and 3),
unearned ESOP compensation was charged to expense as shares of
ESOP Stock were allocated to participants. An amount equivalent
to the preferred dividends declared on the ESOP Stock had
partially offset compensation and interest expense related to the
Non-union ESOP through the close of the joint tender offer.
Interest expense incurred by the Non-union ESOP on its debt to
the Company was $9 million in 1997 and $24 million in 1996 and
1995. Compensation expense related to the Non-union ESOP was $2
million in 1997, $11 million in 1996 and $10 million in 1995.
Prior to its acquisition, the Company made dividend payments at a
rate of 7.51% on the ESOP Stock and additional contributions in
an aggregate amount sufficient to enable the Non-union ESOP to
make the required interest and principal payments on its note to
the Company. Preferred dividends declared were $3 million in
1997, $20 million in 1996 and $21 million in 1995. Preferred
dividend payments of $3 million, $25 million and $21 million were
made in 1997, 1996 and 1995, respectively.
Postretirement Benefits Other Than Pensions
-------------------------------------------
The Company provides health and life insurance benefits to
certain retired non-union employees. Certain non-union employees
are eligible for retiree medical benefits, while substantially
all non-union employees are eligible for retiree life insurance
benefits. Generally, company-provided health care benefits
terminate when individuals reach age 65.
Retiree life insurance plan assets consist of a retiree life in-
surance reserve held in the Company's group life insurance
policy. There are no plan assets for the retiree health benefits
plan.
- 17 -
The following sets forth the plans' funded status reconciled with
amounts reported in the Company's balance sheets:
1997 1996
----------------- -----------------
Life Life
Medical Insurance Medical Insurance
Plan Plan Plan Plan
(In Millions)
Accumulated postretirement
benefit obligation:
Retirees $28 $20 $44 $20
Fully eligible active plan
participants 1 1
Other active plan participants 5 3
--- --- --- ---
Accumulated benefit obligation 29 25 45 23
Market value of plan assets (10) (10)
--- --- --- ---
Accumulated benefit obligation
in excess of plan assets 29 15 45 13
Unrecognized gains and (losses) 9 1 (1) 2
Accrued benefit cost recognized
in the Consolidated Balance --- --- --- ---
Sheet $38 $16 $44 $15
=== === === ===
Net periodic postretirement
benefit cost, primarily
interest cost $ 1 $ 1 $ 3 $ 1
=== === === ===
An 8% percent rate of increase in per capita costs of covered
health care benefits was assumed for 1998, gradually decreasing
to 6% percent by the year 2007. Increasing the assumed health
care cost trend rates by one percentage point in each year would
increase the accumulated postretirement benefit obligation as of
December 31, 1997 by $2 million and would have an immaterial
effect on the net periodic postretirement benefit cost for 1997.
Discount rates of 7.0% and 7.5% were used to determine the
accumulated postretirement benefit obligations for both the
medical and life insurance plans in 1997 and 1996, respectively.
The assumed rate of compensation increase was 6% in both 1997
1996.
Retiree medical benefits are funded by a combination of Company and
retiree contributions. Retiree life insurance benefits are
provided by insurance companies whose premiums are based on claims
paid during the year.
9. Capital Stock
-------------
Preferred Stock
---------------
The Company is authorized to issue 25 million shares of
preferred stock with no par value. The Board of Directors has
- 18 -
the authority to divide the preferred stock into series and to
determine the rights and preferences of each. All of the
Company's shares of ESOP Stock were converted to common shares
when tendered as part of the joint acquisition of the Company's
common stock (Notes 2 and 3).
Employee Benefits Trust
-----------------------
In 1995, the Company issued approximately 4.7 million shares of
its common stock to the Conrail Employee Benefits Trust (the
"Trust") in exchange for a promissory note of $250 million at an
interest rate of 6.9%. As a result of the joint tender offer
(Notes 2 and 3) for the Company's common stock, the Trust repaid
$90 million of the promissory loan with proceeds it received
from the sale of a portion of the common stock it held. The
Trust is expected to fund the payment of employee benefits with
the remaining proceeds it currently holds.
The Trust was intended to fund certain employee benefits and
other forms of compensation over its fifteen-year term. The
amount representing unearned employee benefits is recorded as a
deduction from stockholders' equity and is reduced as benefits
and compensation, including future severance benefits, are paid
from the Trust. Before the close of the joint tender offer for
the Company's common stock, the shares owned by the Trust were
valued at the closing market price as of the end of each
reporting period, with corresponding changes in the balance of
the Trust reflected in additional paid-in capital. Shares held
by the Trust were not considered outstanding for earnings per
share computations until released by the Trust, but did have
voting and dividend rights.
Treasury Stock
--------------
As a result of the acquisition of Conrail, the Company's common
stock repurchase program was terminated in the fourth quarter of
1996. The activity for 1997 is related to the repurchase of
common stock in connection with the repayment of $90 million of
the Trust promissory loan described above. The activity and
status of treasury stock follow:
1997 1996 1995
---------- --------- ---------
Shares, beginning of year 5,523,455 3,297,717 1,789,164
Acquired 2,225,738 1,508,553
Effects of Conrail
acquisition 796,794
---------- --------- ----------
Shares, end of year 6,320,249 5,523,455 3,297,717
========== ========= ==========
Stock Plans
-----------
The Company has applied APB Opinion No. 25, "Accounting for
Stock Issued to Employees" and related interpretations in
accounting for the Conrail plans. Accordingly, no compensation
cost was recognized for the Conrail fixed stock option plans
prior to Conrail's acquisition. However, in connection with the
acquisition of Conrail, all outstanding performance shares and
- 19 -
all outstanding unvested stock options, restricted shares and
phantom shares vested during the second quarter of 1997. The
Company paid all of the amounts due under these arrangements and
recorded a $63 million charge ($39 million after income taxes)
for the related compensation expense.
The Company's 1987 and 1991 Long-Term Incentive Plans authorized
the granting to officers and other key employees of up to
4 million and 6.6 million shares of common stock, respectively,
through stock options, stock appreciation rights, phantom stock
and awards of restricted or performance shares. A stock option
was exercisable for a specified term commencing after grant at a
price not less than the fair market value of the stock on the
date of grant. The vesting of awards made pursuant to these
plans was contingent upon one or more of the following:
continued employment, passage of time or financial and other
performance goals.
The activity and status of stock options under the incentive
plans follow:
Non-qualified Stock Options
-----------------------------------
Option Price Shares
Per Share Under Option
----------------- ------------
Balance, January 1, 1995 $14.000 - $ 66.938 1,363,955
Granted $50.688 - $ 68.563 516,757
Exercised $14.000 - $ 53.875 (200,940)
Canceled $42.625 - $ 53.875 (123,560)
------------
Balance, December 31, 1995 $14.000 - $ 68.563 1,556,212
Granted $68.563 - $ 96.063 551,038
Exercised $14.000 - $ 73.250 (1,268,085)
Canceled $42.625 - $ 70.031 (3,984)
------------
Balance, December 31, 1996 $14.000 - $ 96.063 835,181
Granted $42.625 - $104.438 416,190
Exercised $14.000 - $104.438 (267,294)
Canceled $42.625 - $ 50.688 (6,625)
Purchased due to Conrail
acquisition $14.000 - $104.438 (977,452)
------------
Balance, December 31, 1997 -
============
Available for future grants
December 31, 1996 3,969,317
============
December 31, 1997 -
============
The weighted average exercise prices of options granted during 1996
and 1995 were $70.130 per share and $51.204 per share,
respectively. The weighted average exercise prices of options
exercised during 1996 and 1995 were $48.32 per share and $31.16 per
share, respectively.
- 20 -
Pro forma disclosures of net income and earnings per share as if
the Company had adopted the cost recognition requirements under
SFAS No. 123, "Accounting for Stock-Based Compensation" (SFAS 123)
in 1996 and 1995 are presented below ($ in millions except per
share data):
1996 1995
----- -----
Net income as reported $ 342 $ 264
Net income pro forma 335 262
Basic earnings per share $4.29 $3.21
Basic earnings per share pro forma 4.20 3.19
Diluted earnings per share $3.91 $2.94
Diluted earnings per share pro forma 3.82 2.92
The fair value of each option granted during 1996 was estimated on
the date of grant using the Black-Scholes option-pricing model with
the following weighted average assumptions: (1) dividend yield of
2.43%, (2) expected volatility of 25.25%, (3) risk-free interest
rate of 5.51%, and (4) expected life of 4 years. The weighted
average fair value of options granted during 1996 and 1995 was
$16.00 per share and $13.12 per share, respectively.
Prior to its acquisition, the Company had granted phantom shares
and restricted stock under its non-union employee bonus plans to
eligible employees who elected to defer all or a portion of
their annual bonus in a given year. The number of shares
granted depended on the length of the deferral period. Grants
were made at the market price of the Company's common stock at
the date of grant. The Company had granted 148,749 shares and
337,329 shares of phantom and restricted stock, respectively,
under its non-union employee bonus plans through its acquisition
date of May 23, 1997. The Company had also granted 201,945
performance shares under its 1991 Long-Term Incentive Plan
through its acquisition date. Compensation expense related to
these plans was $2 million in 1996 and $3 million in 1995. The
weighted-average fair value for the phantom shares and
restricted stock granted during 1996 and 1995 was $68.02 per
share and $52.88 per share, respectively. As a result of its
acquisition, the Company paid all of the amounts due to
employees under stock-related compensation arrangements during
the second quarter of 1997 (Note 3).
10. Voluntary Separation Programs
-----------------------------
During 1996, the Company recorded a charge of $135 million
(before tax benefits of $52 million) consisting of $102 million
in termination benefits to be paid to non-union employees
participating in the voluntary retirement and separation
programs ("voluntary separation programs") and losses of $33
- 21 -
million on non-cancelable leases for office space no longer
required as a result of the reduction in the Company's
workforce. Over 840 applications were accepted from eligible
employees under the voluntary separation programs. Approximately
$90 million in benefits are being paid from the Company's
overfunded pension plan.
11. Asset Disposition Charge
------------------------
Included in 1995 operating expenses is an asset disposition
charge of $285 million, which reduced net income by $176 million.
The asset disposition charge resulted from a review of the
Company's route system and other operating assets to determine
those that no longer effectively and economically supported
current and expected operations. The Company identified and
planned to sell 1,800 miles of rail lines that were expected to
provide proceeds substantially less than net book value. In
addition, other assets, principally yards and side tracks,
identified for disposition were written down to estimated net
realizable value (See Note 1 "Asset Impairment"). Currently, the
asset disposition program is under review as a result of the
Conrail acquisition (Note 2).
12. Other Income, Net
-----------------
1997 1996 1995
---- ---- ----
(In Millions)
Interest income $13 $ 29 $ 33
Rental income 41 50 57
Property sales 23 23 27
Other, net 6 10 13
--- ---- ----
$83 $112 $130
=== ==== ====
13. Commitments and Contingencies
-----------------------------
Environmental
-------------
The Company is subject to various federal, state and local laws
and regulations regarding environmental matters. CRC is a party
to various proceedings brought by both regulatory agencies and
private parties under federal, state and local laws, including
Superfund laws, and has also received inquiries from govern-
mental agencies with respect to other potential environmental
issues. At December 31, 1997, CRC has received, together with
other companies, notices of its involvement as a potentially
responsible party or requests for information under the
Superfund laws with respect to cleanup and/or removal costs due
to its status as an alleged transporter, generator or property
owner at 135 locations. However, based on currently available
information, the Company believes CRC may have some potential
responsibility at only 60 of these sites. Due to the number of
parties involved at many of these sites, the wide range of costs
of possible remediation alternatives, the changing technology and
the length of time over which these matters develop, it is often
- 22 -
not possible to estimate CRC's liability for the costs associated
with the assessment and remediation of contaminated sites.
Although the Company's operating results and liquidity could be
significantly affected in any quarterly or annual reporting
period if CRC were held principally liable in certain of these
actions, at December 31, 1997, the Company had accrued $48
million, an amount it believes is sufficient to cover the
probable liability and remediation costs that will be incurred at
Superfund sites and other sites based on known information and
using various estimating techniques. The Company believes the
ultimate liability for these matters will not materially affect
its consolidated financial condition.
The Company spent $9 million in 1997, $11 million in 1996 and
$14 million in 1995 for environmental remediation and related
costs and anticipates spending an amount comparable to that
spent in 1997 during 1998. In addition, the Company's capital
expenditures for environmental control and abatement projects
were approximately $7 million in 1997 and $6 million in 1996
and 1995, and are anticipated to be approximately $11 million
in 1998.
The Environmental Quality Department is charged with promoting
the Company's compliance with laws and regulations affecting
the environment and instituting environmentally sound operating
practices. The department monitors the status of the sites
where the Company is alleged to have liability and continually
reviews the information available and assesses the adequacy of
the recorded liability.
Other
-----
The Company is involved in various legal actions, principally
relating to occupational health claims, personal injuries,
casualties, property damage and damage to lading. The Company
has recorded liabilities for amounts sufficient to cover the
expected payments for such actions.
The Company may be contingently liable for approximately $50
million at December 31, 1997 under indemnification provisions
related to sales of tax benefits.
CRC had an average of 19,802 employees in 1997, approximately
86% of whom are represented by 14 different labor organizations
and are covered by 21 separate collective bargaining agreements.
The Company was not engaged in any collective bargaining at
December 31, 1997.
CRC currently guarantees the principal and interest payments in
the amount of $48 million on Equipment Trust Certificates for
Locomotive Management Services, a general partnership of which
CRC holds a fifty percent interest.
- 23 -
CRC has received an adverse jury verdict related to a railroad
crossing accident in Ohio that includes a significant punitive
damage award that approximates $15 million. CRC believes the
punitive damage award in this case is improper and that it has
meritorious defenses, which it is pursuing on appeal.
The Company, currently, has not taken actions to resolve
anticipated year 2000 issues related to its computer systems since
it believes that such issues will be resolved in connection with
the proposed integration of its systems with those of CSX and NSC
following the requisite STB approval of the Conrail acquisition.
In the event that the STB does not approve the sale of Conrail,
the Company is developing a contingency plan to enable it to
continue to operate into the year 2000 and beyond. While it is
not possible, at this time, to quantify the overall cost of
implementing this contingency plan, the Company believes that it
would be material to its results of operations during the
implementation period. In addition, were the STB to disapprove
the sale of Conrail, the Company believes that failure to develop
and implement such a plan could result in a material financial
risk and serious disruption in its operations.
14. Condensed Quarterly Data (Unaudited)
-----------------------------------
First Second Third Fourth
-------------- -------------- --------------- ---------------
1997 1996 1997 1996 1997 1996 1997 1996
------ ------ ------ ------ ------ ------ ------ ------
($ In Millions Except Per Share)
Revenues $906 $889 $ 937 $949 $944 $933 $978 $943
Income (loss) from operations 116 69 (231) 54 218 235 219 243
Net income (loss) 61 31 (273) 26 101 138 118 147
Net income (loss) per common share:
Basic .74 .36 - .30 - 1.76 - 1.87
Diluted .70 .35 - .29 - 1.58 - 1.70
Ratio of earnings to fixed charges 2.52x 1.75x - 1.57x 4.82x 4.77x 4.76x 4.91x
Dividends per common share .475 .425 - .425 - .475 - .475
Market prices per common share
(New York Stock Exchange)
High 113 1/4 77 1/4 - 73 1/4 - 74 5/8 - 100 7/8
Low 98 1/2 67 5/8 - 66 1/4 - 63 3/4 - 68 1/2
Due to the acquisition of Conrail (Notes 2 and 3), per share data
are not presented for periods subsequent to the first quarter of
1997.
The Company recorded pre-tax merger-related costs of $22 million
($14 million after income taxes), $440 million ($390 million
after income taxes), $23 million ($16 million after income taxes)
and $23 million ($15 million after income taxes) during the
- 24 -
first, second, third and fourth quarters of 1997, respectively.
A $221 million ESOP termination charge (no income tax effect) is
included in the second quarter of 1997 merger-related costs (Note
3). After the merger-related costs were recognized during the
second quarter of 1997, earnings available for fixed charges were
inadequate by $259 million.
A tax law was enacted during the third quarter of 1997 by a state
in which the Company operates which changed the Company's method
of computing taxes and resulted in a tax rate increase. Income
tax expense for the third quarter was increased by $22 million
representing the effects of adjusting deferred income taxes and
the special income tax obligation for the rate increase as
required by SFAS 109 (Note 7).
During the second quarter of 1996, the Company recorded a one-
time charge of $135 million for the non-union employee voluntary
early retirement and separation programs and related costs, which
reduced net income by $83 million (Note 10). During the fourth
quarter of 1996, the Company recorded merger-related costs of $16
million ($10 million after income taxes) (Note 3).
- 25 -
Schedule II
CONRAIL INC.
VALUATION AND QUALIFYING ACCOUNTS
FOR THE YEARS ENDED DECEMBER 31,
(In Millions)
Additions
----------------------
Balance at Charged to Charged Balance
Beginning Costs and to Other At End
Description of Period Expenses Accounts Deductions of Period
- ----------- ------------ ---------- --------- ------------ -----------
(1)
1995
Casualty reserves
Current............... $103 $ 3 $ (4) (2) $110
Noncurrent............ 212 $171 14 180 (3) 217
Allowance for disposition
of property and
equipment (4)(5)........ 241 261 63 439
1996
Casualty reserves
Current............... 110 (31) (2) 141
Noncurrent............ 217 165 11 203 (3) 190
Allowance for disposition
of property and
equipment (4) .......... 439 31 408
1997
Casualty reserves
Current............... 141 1 1 (2) 141
Noncurrent............ 190 127 14 133 (3) 198
Allowance for disposition
of property and
equipment (4)............ 408 16 392
(1) Includes charges to property accounts in connection with
construction projects and the recording of receivables from third
parties.
(2) Includes net transfers from noncurrent.
(3) Includes net transfers to current.
(4) Deductions of $63 million, $31 million and $16 million in 1995,
1996 and 1997, respectively, represent net losses on asset
dispositions.
(5) In 1995, the Company recorded an asset disposition charge, which
resulted from a review of the Company's route system and other
operating assets to determine those that no longer effectively and
economically support current and expected operations. The Company
identified and planned to sell 1,800 miles of rail lines that were
expected to provide proceeds substantially less than net book value.
In addition, other assets, principally yards and side tracks,
identified for disposition have been written down to estimated net
realizable value.(See Note 11 to the Consolidated Financial
Statements.)