NSC 2002 Form 10-K

UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

(X)

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

 

EXCHANGE ACT OF 1934

 

For the fiscal year ended DECEMBER 31, 2002

 

 

( )

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES

 

EXCHANGE ACT OF 1934

 

For the transition period from _________ to _________

Commission file number 1-8339

 

 

NORFOLK SOUTHERN CORPORATION

(Exact name of registrant as specified in its charter)

Virginia

52-1188014

(State or other jurisdiction of

(IRS Employer Identification No.)

incorporation or organization)

 

 

 

Three Commercial Place

 

Norfolk, Virginia

23510-2191

(Address of principal executive offices)

Zip Code

 

 

Registrant's telephone number, including area code

(757) 629-2680

 

 

No Change

(Former name, former address and former fiscal year, if changed since last report.)

 

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each Class

Name of each exchange

Norfolk Southern Corporation

on which registered

Common Stock (Par Value $1.00)

New York Stock Exchange

 

 

Securities registered pursuant to Section 12(g) of the Act: NONE

 

Indicate by check mark whether the registrant (1) has filed all report 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  (   )

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.          (X)

 

The number of shares outstanding of each of the registrant's classes of common stock, as of January 31, 2003:

389,057,174 (excluding 21,169,125 shares held by registrant's consolidated subsidiaries).

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act).  Yes  (X)   No  (  )

 

The aggregate market value of the voting common equity held by nonaffiliates as of June 28, 2002 was $9,079,736,767 (based on the closing price as quoted on the New York Stock Exchange on that date).

 

DOCUMENTS INCORPORATED BY REFERENCE:

 

Portions of the Registrant's definitive proxy statement to be filed electronically pursuant to Regulation 14A not later than 120 days after the end of the fiscal year, are incorporated by reference in Part III.

 

 

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TABLE OF CONTENTS

 

NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES (NS)

 


 

Page

 

 

 

Part I.

1.    Business

K3

 

2.    Properties

K3

 

3.    Legal Proceedings

K12

 

4.    Submission of Matters to a Vote of Security Holders

K12

 

       Executive Officers of the Registrant

 

 

 

 

Part II.

5.    Market for Registrant's Common Stock and Related Stockholders Matters

K14

 

6.    Selected Financial Data

K15

 

7.    Management's Discussion and Analysis of Financial Condition and Results

 

 

       of Operations

K16

 

7A. Quantitative and Qualitative Disclosures About Market Risk

K35

 

8.    Financial Statements and Supplementary Data

K36

 

9.    Changes in and Disagreements with Accountants on Accounting and

 

 

       Financial Disclosure

K66

 

 

 

Part III.

10. Directors and Executive Officers of the Registrant

K66

 

11. Executive Compensation

K66

 

12. Security Ownership of Certain Beneficial Owners and Management

K66

 

13. Certain Relationships and Related Transactions

K69

 

 

 

 

14.   Controls and Procedures

K69

 

 

 

Part IV.

15. Exhibits, Financial Statement Schedule and Reports on Form 8-K

K70

 

        Index to Consolidated Financial Statement Schedule

 

 

 

 

 

Power of Attorney

K76

 

 

 

 

Signatures

K76

 

 

 

 

Certifications of CEO and CFO

K78

 

 

 

 

Exhibit Index

K81

 

 

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PART I

 

NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES (NS)

 

 

Item 1. Business. and Item 2. Properties.

 

GENERAL - Norfolk Southern Corporation (Norfolk Southern) was incorporated on July 23, 1980, under the laws of the Commonwealth of Virginia. On June l, 1982, Norfolk Southern acquired control of two major operating railroads, Norfolk and Western Railway Company (NW) and Southern Railway Company (Southern) in accordance with an Agreement of Merger and Reorganization dated as of July 31, 1980, and with the approval of the transaction by the Interstate Commerce Commission (ICC) (now the Surface Transportation Board [STB]).

 

Effective Dec. 31, 1990, Norfolk Southern transferred all the common stock of NW to Southern, and Southern's name was changed to Norfolk Southern Railway Company (Norfolk Southern Railway). Effective Sept. 1, 1998, NW was merged with and into Norfolk Southern Railway. As of Dec. 31, 2002, all the common stock of Norfolk Southern Railway and 22.5% of its voting preferred stock (resulting in 95.2% voting control) was owned directly by Norfolk Southern.

 

Through a jointly owned entity, Norfolk Southern and CSX Corporation (CSX) own the stock of Conrail Inc., which owns the major freight railroad in the Northeast. Norfolk Southern has a 58% economic and 50% voting interest in the jointly owned entity. See also the discussion concerning operation of a portion of Conrail's rail assets, below.

 

On March 28, 1998, Norfolk Southern closed the sale of its motor carrier company, North American Van Lines, Inc. (NAVL) (see "Discontinued Operations" and Note 17). NAVL's results are presented as "Discontinued operations" in the accompanying financial information.

 

Norfolk Southern makes available free of charge through its website, www.nscorp.com, its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission.

 

Unless indicated otherwise, Norfolk Southern and its subsidiaries are referred to collectively as NS.

 

OPERATION OF A PORTION OF THE CONRAIL RAIL ASSETS - On June 1, 1999, Norfolk Southern and CSX, through their respective railroad subsidiaries, began operating separate portions of Conrail's rail routes and assets. Substantially all such assets are owned by two wholly owned subsidiaries of Consolidated Rail Corporation (CRC); one of those subsidiaries, Pennsylvania Lines LLC (PRR), has entered into various operating and leasing arrangements, more particularly described in Note 2, with Norfolk Southern Railway. Certain rail assets (Shared Assets Areas) still are owned by CRC, which operates them for joint and exclusive use by Norfolk Southern Railway and the rail subsidiary of CSX.

 

Operation of the PRR routes and assets increased the size of the system over which Norfolk Southern Railway provides service by nearly 50% and afforded access to the New York metropolitan area, to

much of the Northeast and to most of the major East Coast ports north of Norfolk, Virginia. Also, leasing arrangements with PRR augmented Norfolk Southern Railway's locomotive, freight car and intermodal fleet.

 

RAILROAD OPERATIONS - As of Dec. 31, 2002, NS' railroads operated approximately 21,500 miles of road in the states of Alabama, Delaware, Florida, Georgia, Illinois, Indiana, Iowa, Kentucky, Louisiana, Maryland, Michigan, Mississippi, Missouri, New Jersey, New York, North Carolina, Ohio, Pennsylvania, South Carolina, Tennessee, Virginia, West Virginia, the District of Columbia and in the Province of Ontario, Canada. The miles operated were as follows:

 

 

 

K3

 

Mileage Operated as of Dec. 31, 2002

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Passing

 

 

 

 

 

 

 

 

 

 

Track,

 

 

 

 

 

 

Miles of Road

 

Second and Other Main Track

 

Crossovers and Turnouts

 

Way and Yard Switching

 

Total

 

 

 

 

 

 

 

 

 

 

 

Owned

 

11,745

 

1,384

 

1,625

 

5,969

 

20,723

Operated under lease,

 

 

 

 

 

 

 

 

 

 

  contract or trackage rights

 

9,813

 

3,441

 

891

 

3,647

 

17,792

      Total

 

21,558

 

4,825

 

2,516

 

9,616

 

38,515

 

In addition to the lines leased from Conrail previously discussed, NS' railroads have major leased lines between Cincinnati, Ohio, and Chattanooga, Tennessee, and operate over trackage owned by North Carolina Railway Company (NCRR). The Cincinnati-Chattanooga lease, covering about 335 miles of road, expires in 2026, and is subject to an option to extend the lease for an additional 25 years, at terms to be agreed upon. The trackage rights over NCRR cover approximately 315 miles of road under an agreement through 2014 with the right to renew for two additional 15-year periods.

 

NS' railroads carry raw materials, intermediate products and finished goods primarily in the Southeast, East and Midwest, and via interchange with other rail carriers, to and from the rest of the United States and parts of Canada. They also transport overseas freight through several Atlantic and Gulf Coast ports. Atlantic ports served by NS include: Norfolk, Virginia; Morehead City, North Carolina; Charleston, South Carolina; Savannah and Brunswick, Georgia; Jacksonville, Florida; Baltimore, Maryland; Philadelphia, Pennsylvania/Camden, New Jersey; Wilmington, Delaware; and the Ports of New York/New Jersey. Gulf Coast ports served include Mobile, Alabama, and New Orleans, Louisiana.

 

The lines of NS' railroads reach most of the larger industrial and trading centers of the Southeast, Northeast, Mid-Atlantic region and Midwest. Chicago, Norfolk, Detroit, Atlanta, Metropolitan New York City, Jacksonville, Kansas City (Missouri), Baltimore, Buffalo, Charleston, Cleveland, Columbus, Philadelphia, Pittsburgh, Toledo, Greensboro, Charlotte and Savannah are among the leading centers originating and terminating freight traffic on the system. In addition, haulage arrangements with connecting carriers allow NS' railroads to provide single-line service to and from additional markets, including haulage provided by Florida East Coast Railway Company to serve southern and eastern Florida, including the port cities of Miami, West Palm Beach and Fort Lauderdale; and haulage provided by The Kansas City Southern Railway Company to provide transcontinental intermodal service via a connection with the Burlington Northern and Santa Fe Railway Company. Service is provided to New England, including the Port of Boston, via haulage, trackage rights and interline arrangements with Canadian Pacific Railway Company and Guilford Transportation Industries. The system's lines also reach many individual industries, electric generating facilities, mines (in western Virginia, eastern Kentucky, southern and northern West Virginia and western Pennsylvania), distribution centers, transload facilities and other businesses located in smaller communities in its service area. The traffic corridors carrying the heaviest volumes of freight include those from the New York City area to Chicago (via Allentown and Pittsburgh); Chicago to Jacksonville (via Cincinnati, Chattanooga and Atlanta); Appalachian coal fields of Virginia, West Virginia and Kentucky, to Norfolk and Sandusky, Ohio; Cleveland to Kansas City; and Knoxville to Chattanooga. Chicago, Memphis, Sidney/Salem, New Orleans, Kansas City, Buffalo, St. Louis and Meridian are major gateways for interterritorial system traffic.

 

Triple Crown Operations - Until April 1993, NS' intermodal subsidiary, Triple Crown Services, Inc. (TCS), offered intermodal service using RoadRailer® equipment and domestic containers. RoadRailer® units are enclosed vans that can be pulled over highways in tractor-trailer configuration and over the rails by locomotives. On April 1, 1993, the business, name and operations of TCS were transferred to Triple Crown Services Company (TCSC), a partnership in which subsidiaries of NS and Conrail are equal partners. From April 1, 1993, to June 1, 1999, the revenues of TCSC were not consolidated with the results of NS; however, effective June 1, 1999, NS gained control of TCSC and, therefore, now includes TCSC's results in its

 

K4


consolidated financial statements. TCSC offers door-to-door intermodal service using RoadRailer® equipment in major traffic corridors, including those between the Midwest and the Northeast, the Midwest and the Southeast and the Midwest and Texas/Mexico.

 

The following table sets forth certain statistics relating to NS railroads' operations for the past 5 years, including operations in the Northern Region that commenced June 1, 1999:

 

Rail Operating Statistics

 

 

 

Year Ended Dec. 31,

 

2002

2001

2000

1999

1998

 

 

 

 

 

 

Revenue ton miles (billions)

179  

182   

197   

167   

135   

Freight train miles traveled (millions)

72.6  

70.0   

74.4   

61.5   

53.0   

Revenue per ton mile

$0.0350  

$0.0339   

$0.0312   

$0.0315   

$0.0316   

Revenue ton miles per

 

 

 

 

 

  man-hour worked

3,067  

3,023   

2,888   

2,577   

2,659   

Percentage ratio of railway operating

 

 

 

 

 

  expenses to railway operating revenues

81.5%

83.7%

89.7%

86.3%

75.3%

 

RAILWAY OPERATING REVENUES - NS' total railway operating revenues were $6.3 billion in 2002. Revenue, shipments and revenue yield by principal railway operating revenue sources for the past five years are set forth in the following table.

 

Principal Sources of Railway Operating Revenues

 

 

 

Year Ended Dec. 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

2002

 

2001

 

2000

 

1999

 

1998

(Revenues in millions, shipments in thousands, revenue yield in dollars per shipment)

 

 

 

 

 

 

 

 

 

 

 

COAL

 

 

 

 

 

 

 

 

 

 

  Revenues

$

1,441   

$

1,521   

$

1,435   

$

1,322   

$

1,252   

    % of total revenues

 

23%

 

25%

 

23%

 

25%

 

29%

  Shipments

 

1,610   

 

1,695   

 

1,687   

 

1,519   

 

1,310   

    % of total shipments

 

24%

 

26%

 

25%

 

25%

 

27%

  Revenue Yield

$

895   

$

897   

$

850   

$

870   

$

955   

 

 

 

 

 

 

 

 

 

 

 

AUTOMOTIVE

 

 

 

 

 

 

 

 

 

 

  Revenues

$

961   

$

885   

$

921   

$

746   

$

577   

    % of total revenues

 

15%

 

14%

 

15%

 

14%

 

13%

  Shipments

 

662   

 

622   

 

692   

 

611   

 

487   

    % of total shipments

 

10%

 

9%

 

10%

 

10%

 

10%

  Revenue Yield

$

1,450   

$

1,423   

$

1,331   

$

1,220   

$

1,186   

 

 

 

 

 

 

 

 

 

 

 

CHEMICALS

 

 

 

 

 

 

 

 

 

 

  Revenues

$

769   

$

752   

$

756   

$

641   

$

492   

    % of total revenues

 

12%

 

12%

 

13%

 

12%

 

12%

  Shipments

 

434   

 

432   

 

453   

 

394   

 

315   

    % of total shipments

 

6%

 

6%

 

6%

 

7%

 

7%

  Revenue Yield

$

1,773   

$

1,742   

$

1,668   

$

1,627   

$

1,559   

 

 

 

 

 

 

 

 

 

 

 

 

 

K5

1


Principal Sources of Railway Operating Revenues (continued)

 

 

 

Year Ended Dec. 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

2002

 

2001

 

2000

 

1999

 

1998

(Revenues in millions, shipments in thousands, revenue yield in dollars per shipment)

 

 

 

 

 

 

 

 

 

 

 

METALS/CONSTRUCTION

 

 

 

 

 

 

 

 

 

 

  Revenues

$

692   

$

674   

$

689   

$

567   

$

375   

    % of total revenues

 

11%

 

11%

 

11%

 

11%

 

9%

  Shipments

 

716   

 

703   

 

757   

 

587   

 

372   

    % of total shipments

 

11%

 

11%

 

11%

 

10%

 

8%

  Revenue Yield

$

966   

$

959   

$

911   

$

965   

$

1,008   

 

 

 

 

 

 

 

 

 

 

 

AGR./CONSUMER

 

 

 

 

 

 

 

 

 

 

  PRODUCTS/GOVT.

 

 

 

 

 

 

 

 

 

 

  Revenues

$

623   

$

603   

$

609   

$

539   

$

468   

    % of total revenues

 

10%

 

10%

 

10%

 

11%

 

11%

  Shipments

 

507   

 

509   

 

525   

 

489   

 

441   

    % of total shipments

 

8%

 

8%

 

8%

 

8%

 

9%

  Revenue Yield

$

1,228   

$

1,185   

$

1,160   

$

1,103   

$

1,063   

 

 

 

 

 

 

 

 

 

 

 

PAPER/CLAY/FOREST

 

 

 

 

 

 

 

 

 

 

  Revenues

$

603   

$

612   

$

630   

$

578   

$

535   

    % of total revenues

 

10%

 

10%

 

10%

 

11%

 

13%

  Shipments

 

438   

 

450   

 

491   

 

465   

 

445   

    % of total shipments

 

6%

 

7%

 

7%

 

8%

 

9%

  Revenue Yield

$

1,378   

$

1,357   

$

1,285   

$

1,243   

$

1,202   

 

 

 

 

 

 

 

 

 

 

 

INTERMODAL

 

 

 

 

 

 

 

 

 

 

  Revenues

$

1,181   

$

1,123   

$

1,119   

$

849   

$

555   

    % of total revenues

 

19%

 

18%

 

18%

 

16%

 

13%

  Shipments

 

2,354   

 

2,214   

 

2,242   

 

1,896   

 

1,443   

    % of total shipments

 

35%

 

33%

 

33%

 

32%

 

30%

  Revenue Yield

$

502   

$

507   

$

499   

$

448   

$

385   

 

 

 

 

 

 

 

 

 

 

 

TOTALS

 

 

 

 

 

 

 

 

 

 

  Railway Operating  Revenues

$

6,270   

$

6,170   

$

6,159   

$

5,242   

$

4,254   

  Railway Shipments

 

6,721   

 

6,625   

 

6,847   

 

5,961   

 

4,813   

  Railway Revenue Yield

$

933   

$

931   

$

900   

$

879   

$

884   

 

COAL TRAFFIC - Coal, coke and iron ore -- most of which is bituminous coal -- is NS' railroads' largest commodity group as measured by revenues. The railroads handled a total of 170.4 million tons in 2002, most of which originated on NS' lines in West Virginia, Virginia, Pennsylvania and Kentucky. Revenues from coal, coke and iron ore accounted for about 23% of NS' total railway operating revenues in 2002.

 

Coal, coke and iron ore tonnage by market for the past five years are set forth in the following table.

 

 

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Coal, Coke and Iron Ore Tonnage by Market

 

 

 

Year Ended December 31,

 

2002

 

2001

 

2000

 

1999

 

1998

 

(tons in thousands)

 

 

 

 

 

 

 

 

 

 

Utility

127,747

 

132,325

 

119,284

 

107,381

 

83,225

Export

11,342

 

13,872

 

19,845

 

18,373

 

24,453

Steel

21,578

 

20,457

 

25,003

 

21,399

 

18,236

Industrial

9,733

 

11,377

 

10,781

 

10,348

 

8,382

 

170,400

 

178,031

 

174,913

 

157,501

 

134,296

 

Total coal handled through all system ports in 2002 was 32 million tons. Of this total, 10 million tons (including coastwise traffic) moved through Lamberts Point, Virginia, 3 million tons moved through the Baltimore Terminal, 11 million tons moved to various docks on the Ohio River, and 8 million tons moved to various Lake Erie ports. Other than coal for export, virtually all coal handled by NS' railroads was terminated in states east of the Mississippi River.

 

See the discussion of coal traffic, by type of coal, in Part II, Item 7, "Management's Discussion and Analysis."

 

GENERAL Merchandise Traffic - General merchandise traffic is composed of five major commodity groupings:  automotive; chemicals; metals and construction; agriculture, consumer products and government; and paper, clay and forest products. The automotive group includes finished vehicles for BMW, Daimler Chrysler, Ford Motor Company, General Motors, Honda, Isuzu, Jaguar, Land Rover, Mazda, Mercedes-Benz, Mitsubishi, Nissan, Saab, Subaru, Suzuki, Toyota and Volkswagen, and auto parts for Ford Motor Company, General Motors, Mercedes-Benz and Toyota. The chemicals group includes sulfur and related chemicals, petroleum products, chlorine and bleaching compounds, plastics, rubber, industrial chemicals, chemical wastes and municipal wastes. The metals and construction

group includes steel, aluminum products, machinery, scrap metals, cement, aggregates, bricks and minerals. The agriculture, consumer products and government group includes soybeans, wheat, corn, fertilizer, animal and poultry feed, food oils, flour, beverages, canned goods, sweeteners, consumer products and items for the military. The paper, clay and forest products group includes lumber and wood products, pulpboard and paper products, woodfibers, woodpulp, scrap paper and clay. General merchandise carloads handled in 2002 were 2.76 million, compared with 2.72 million handled in 2001, an increase of 2%.

 

In 2002, 134 million tons of general merchandise freight, or approximately 67% of total general merchandise tonnage handled by NS, originated online. The balance of general merchandise traffic was received from connecting carriers at interterritorial gateways. The principal interchange points for NS-received traffic included Chicago, Memphis, New Orleans, Cincinnati, Kansas City, Detroit, Hagerstown, St. Louis/East St. Louis and Louisville.

 

See the discussion of general merchandise rail traffic by commodity group in Part II, Item 7, "Management's Discussion and Analysis."

 

INTERMODAL TRAFFIC - The intermodal market consists of shipments moving in trailers, domestic and international containers, and Roadrailer® equipment. These shipments are handled on behalf

of intermodal marketing companies, international steamship lines, truckers and other shippers. Intermodal units handled in 2002 were 2.35 million, compared with 2.21 million handled in 2001,

an increase of 6%.

 

See the discussion of intermodal traffic in Part II, Item 7, "Management's Discussion and Analysis."

 

 

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FREIGHT RATES - In 2002, NS' railroads continued their reliance on private contracts and exempt price quotes as their predominant pricing mechanisms. Thus, a major portion of NS' railroads' freight business is not currently economically regulated by the government. In general, market forces have been substituted for government regulation and now are the primary determinant of rail service prices. However, in 2002 there were significant coal movements moving under common carrier (tariff) rates which had previously moved under rates contained in transportation contracts. Beginning Jan. 1, 2002, coal moving to Duke Energy's (Duke) Belew's Creek, Allen, Buck and Dan River generating stations moved under common carrier rates and beginning April 1, 2002, coal moving to Carolina Power and Light's (CP&L) Hyco and Mayo plants moved under common carrier rates. Duke and CP&L have challenged the reasonableness of these common carrier rates in proceedings currently pending before the Surface Transportation Board.

 

In 2002, NS' railroads were found by the STB not to be "revenue adequate" based on results for the year 2001. A railroad is "revenue adequate" under the applicable law when its return on net investment exceeds the rail industry's composite cost of capital. This determination is made pursuant to statutory requirement and does not adversely impact NS' liquidity or capital resources.

 

PASSENGER OPERATIONS - Regularly scheduled passenger trains are operated by Amtrak on NS' lines between Alexandria and New Orleans, and between Greensboro and Selma, North Carolina. Commuter trains are operated on the NS line between Manassas and Alexandria in accordance with contracts with two transportation commissions of the Commonwealth of Virginia. NS also leases the Chicago to Manhattan, Illinois, line to the Commuter Rail Division of the Regional Transportation Authority of Northeast Illinois. Since June 1, 1999, Norfolk Southern Railway has operated former Conrail lines on which Amtrak conducts regularly scheduled passenger operations between Chicago, Illinois, and Detroit, Michigan, and between Chicago and Harrisburg, Pennsylvania.

 

Also since June 1, 1999, through its operation of PRR's routes, Norfolk Southern Railway has been providing freight service over former Conrail lines with significant ongoing Amtrak and commuter passenger operations, and is conducting freight operations over some trackage owned by Amtrak or by New Jersey Transit, the Southeastern Pennsylvania Transportation Authority, Metro-North Commuter Railway Company and Maryland DOT. Finally, passenger operations are conducted either by Amtrak or by the commuter agencies over trackage owned by Pennsylvania Lines LLC, or by Conrail in the Shared Assets Areas.

 

NONCARRIER OPERATIONS - NS' noncarrier subsidiaries engage principally in the acquisition, leasing and management of coal, oil, gas and minerals; the development of commercial real estate; telecommunications; and the leasing or sale of rail property and equipment. In 2002, no such noncarrier subsidiary or industry segment grouping of noncarrier subsidiaries met the requirements for a reportable business segment set forth in Statement of Financial Accounting Standards No. 131.

 

 

RAILWAY PROPERTY

 

The NS railroad system extends across 22 states and portions of Canada. The railroad infrastructure makes the company very capital intensive with total property of approximately $11 billion and investment in Conrail of approximately $6 billion.

 

 

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Capital Expenditures - Capital expenditures for road, equipment and other property for the past five years were as follows (including capitalized leases):

 

 

Capital Expenditures

 

 

2002

 

2001

 

2000

 

1999

 

1998

 

($ in millions)

Road

$

519

$

505

$

557

$

559

$

612

Equipment

 

174

 

233

 

146

 

349

 

442

Other property

 

2

 

8

 

28

 

4

 

6

  Total

$

695

$

746

$

731

$

912

$

1,060

 

Capital spending and maintenance programs are and have been designed to assure the ability to provide safe, efficient and reliable transportation services. For 2003, NS has budgeted $798 million of capital spending. See the discussion following "Cash used for investing activities," in Part II, Item 7, "Management's Discussion and Analysis."

 

Equipment - As of Dec. 31, 2002, NS owned or leased the following units of equipment:

 

 

Number of Units

Capacity

 

 

Owned*

 

Leased**

 

Total

of Equipment

 

 

 

 

 

 

 

 

 

Locomotives:

 

 

 

 

 

 

(Horsepower)

  Multiple purpose

 

2,259

 

1,001

 

3,260

 

10,959,200

  Switching

 

105

 

102

 

207

 

302,800

  Auxiliary units

 

59

 

18

 

77

 

0

     Total locomotives

 

2,423

 

1,121

 

3,544

 

11,262,000

 

 

 

 

 

 

 

 

 

Freight cars:

 

 

 

 

 

 

(Tons)

  Hopper

 

18,568

 

5,036

 

23,604

 

2,486,500

  Box

 

17,184

 

4,438

 

21,622

 

1,687,530

  Covered hopper

 

9,956

 

3,097

 

13,053

 

1,423,216

  Gondola

 

27,619

 

11,077

 

38,696

 

4,148,610

  Flat

 

3,420

 

1,485

 

4,905

 

363,566

  Caboose

 

169

 

57

 

226

 

0

  Other

 

3,375

 

0

 

3,375

 

172,247

     Total freight cars

 

80,291

 

25,190

 

105,481

 

10,281,669

 

 

 

 

 

 

 

 

 

Other:

 

 

 

 

 

 

 

 

  Work equipment

 

4,619

 

1,584

 

6,203

 

 

  Vehicles

 

3,529

 

1,063

 

4,592

 

 

  Highway trailers and

 

 

 

 

 

 

 

 

    containers

 

881

 

7,397

 

8,278

 

 

  RoadRailer®

 

5,570

 

--

 

5,570

 

 

  Miscellaneous

 

1,431

 

10,185

 

11,616

 

 

     Total other

 

16,030

 

20,229

 

36,259

 

 

 

 

 

 

 

 

 

 

 

* Includes equipment leased to outside parties and equipment subject to equipment trusts, conditional sale agreements and capitalized leases.

** Includes locomotives, freight cars and units of other equipment leased from PRR.

 

 

K9


The following table indicates the number and year built for locomotives and freight cars owned at Dec. 31, 2002.

 

 

Year Built

 

 

 

 

 

 

1993-

1988-

1987 &

 

 

2002

2001

2000

1999

1998

1997

1992

Before

Total

Locomotives:

 

 

 

 

 

 

 

 

 

  No. of units

--   

160   

60   

147   

119   

420   

257   

1,260   

2,423   

  % of fleet

--%

7%

2%

6%

5%

17%

11%

52%

100%

 

 

 

 

 

 

 

 

 

 

Freight cars:

 

 

 

 

 

 

 

 

 

  No. of units

--   

--   

112   

515   

1,566   

6,048   

6,098   

65,952   

80,291   

  % of fleet

--%

--%

--%

1%

2%

7%

8%

82%

100%

 

As of Dec. 31, 2002, the average age of the locomotive fleet was 16.1 years. During 2002, 52 locomotives, the average age of which was 28.2 years, were retired. The average age of the freight car fleet at Dec. 31, 2002, was 25.9 years. During 2002, 3,013 freight cars were retired.

 

Since 1988, about 29,000 coal cars have been rebodied. As a result, the remaining serviceability of the freight car fleet is greater than may be inferred from the high percentage of freight cars built in earlier years.

 

 

Annual Average Bad Order Ratio

 

2002

2001

2000

1999

1998

 

 

 

 

 

 

Freight cars (excluding cabooses):

 

 

 

 

 

     NS Rail

8.1%

6.9%

5.7%

3.7%

4.1%

Locomotives:

 

 

 

 

 

      NS Rail

6.3%

5.8%

5.5%

5.3%

4.3%

 

Ongoing freight car and locomotive maintenance programs are intended to ensure the highest standards of safety, reliability, customer satisfaction and equipment marketability. In past years, the freight car bad order ratio reflected the storage of certain types of cars that were not in high demand. The ratio rose in 2000, 2001 and 2002 as a result of decreased maintenance activity. A review began in 2002 to address several hundred unserviceable, overage and commercially obsolete freight cars, which will likely result in their disposition in 2003. The locomotive bad order ratio includes units out of service for required inspections every 92 days and program work such as overhauls. The increase in the locomotive bad order ratio in 1999 was primarily due to the maintenance requirements of units being rented to meet short-term needs and to weather-related failures. The ratio rose slightly in 2000 as maintenance activities were curtailed in response to a slowing economy. The elevated ratio through 2001 and 2002 reflected units out of service related to the resumption of maintenance and modification activities.

 

Track Maintenance - Of the approximately 38,500 total miles of track operated, NS had responsibility for maintaining about 31,000 miles of track with the remainder being operated under trackage rights. Over 75% of the main line trackage (including first, second, third and branch main tracks, all excluding trackage rights) has rail ranging from 131 to 155 pounds per yard with the standard installation currently at 141 pounds per yard. Approximately 40% of NS lines carried 20 million or more gross tons per track mile.

 

 

K10


The following table summarizes several measurements regarding NS' track roadway additions and replacements during the past five years:

 

 

2002

2001

2000

1999

1998

 

 

 

 

 

 

Track miles of rail installed

235

254

390

403

429

Miles of track surfaced

5,270

3,836

3,687

5,087

4,715

New crossties installed (millions)

2.8

1.5

1.5

2.3

2.0

 

Microwave System - The NS microwave system, consisting of approximately 7,282 radio route miles, 442 active stations and 4 passive repeater stations, provides communications between most operating locations. The microwave system is used primarily for voice communications, VHF radio control circuits, data and facsimile transmissions, traffic control operations and AEI data transmissions.

 

Traffic Control - Of a total of 21,500 route miles operated by NS, excluding trackage rights over foreign lines, 11,511 miles are signalized, including 8,546 miles of centralized traffic control (CTC) and 2,965 miles of automatic block signals. Of the 8,546 miles of CTC, 1,895 miles are controlled by data radio originating at 148 base station radio sites.

 

Computers - A computer network consisting of a centralized data center in Atlanta, Georgia, and various distributed computers throughout the company connects the yards, terminals, transportation offices, rolling stock repair points, sales offices and other key system locations. Operating and traffic data are processed and stored to provide customers with information on their shipments throughout the system. Computer systems provide current information on the location of every train and each car on line, as well as related waybill and other train and car movement data. In addition, the computer systems are utilized to assist management in the performance of a variety of functions and services including payroll, car and revenue accounting, billing, material management activities and controls, and special studies.

 

Other - The railroads have extensive facilities for support of operations, including freight depots, car construction shops, maintenance shops, office buildings, and signals and communications facilities.

 

Encumbrances - Certain railroad equipment is subject to the prior lien of equipment financing obligations amounting to approximately $864 million as of Dec. 31, 2002, and $895 million at Dec. 31, 2001.

 

Environmental Matters - Compliance with federal, state and local laws and regulations relating to the protection of the environment is a principal NS goal. To date, such compliance has not affected materially NS' capital additions, earnings, liquidity or competitive position. See the discussion of "Environmental Matters" in Part II, Item 7, "Management's Discussion and Analysis," and in Note 18 to the Consolidated Financial Statements.

 

EMPLOYEES - NS employed an average of 28,970 employees in 2002, compared with an average of 30,894 in 2001. The decrease reflects NS' continuous drive to operate more efficiently, accompanied by railroad retirement legislation late in 2001, which lowered the retirement age for rail employees. The approximate average cost per employee during 2002 was $54,000 in wages and $24,000 in employee benefits.

 

Approximately 85% of NS' railroad employees are covered by collective bargaining agreements with 15 different labor unions. See the discussion of "Labor Agreements" in Part II, Item 7, "Management's Discussion and Analysis."

 

GOVERNMENT REGULATION - In addition to environmental, safety, securities and other regulations generally applicable to all businesses, NS' railroads are subject to regulation by the STB, which succeeded the ICC on Jan. 1, 1996. The STB has jurisdiction over some rates, routes, conditions of service and the extension or abandonment of rail lines. The STB also has jurisdiction over the consolidation, merger or acquisition of control of and by rail common carriers. The Department of Transportation regulates certain track and mechanical equipment standards.

 

The relaxation of economic regulation of railroads, begun over two decades ago by the ICC under the Staggers Rail Act of 1980, has continued under the STB. Significant exemptions are TOFC/COFC (i.e., "piggyback")

 

 

K11

business, rail boxcar traffic, lumber, manufactured steel, automobiles and certain bulk commodities such as sand, gravel, pulpwood and wood chips for paper manufacturing. Transportation contracts on regulated shipments effectively remove those shipments from regulation as well. About 80% of NS' freight revenues come from either exempt traffic or traffic moving under transportation contracts.

 

Efforts may be made in 2003 to re-subject the rail industry to unwarranted federal economic regulation. The Staggers Rail Act of 1980, which substantially reduced such regulation, encouraged and enabled rail carriers to innovate and to compete for business, thereby contributing to the economic health of the nation and to the revitalization of the industry. Accordingly, NS will oppose efforts to reimpose unwarranted economic regulation.

 

COMPETITION - There is continuing strong competition among rail, water and highway carriers. Price is usually only one factor of importance as shippers and receivers choose a transport mode and specific hauling company. Inventory carrying costs, service reliability, ease of handling and the desire to avoid loss and damage during transit are also important considerations, especially for higher-valued finished goods, machinery and consumer products. Even for raw materials, semifinished goods and work-in-process, users are increasingly sensitive to transport arrangements that minimize problems at successive production stages.

 

NS' primary rail competitor is the CSX system; both operate throughout much of the same territory. Other railroads also operate in parts of the territory. NS also competes with motor carriers, water carriers and with shippers who have the additional option of handling their own goods in private carriage.

 

Certain marketing strategies between railroads and between railroads and motor carriers enable carriers to compete more effectively in specific markets.

 

 

Item 3. Legal Proceedings.

 

None.

 

 

Item 4. Submission of Matters to a Vote of Security Holders.

 

There were no matters submitted to a vote of security holders during the fourth quarter of 2002.

 

 

Executive Officers of the Registrant.

 

Norfolk Southern's executive officers generally are elected and designated annually by the Board of Directors at its first meeting held after the annual meeting of stockholders, and they hold office until their successors are elected. Executive officers also may be elected and designated throughout the year as the Board of Directors considers appropriate. There are no family relationships among the officers, nor any arrangement or understanding between any officer and any other person pursuant to which the officer was selected. The following table sets forth certain information, as of February 1, 2003, relating to the executive officers.

 

 

K12

Name, Age, Present Position

Business Experience During Past Five Years

 

 

David R. Goode, 62,

Present position since September 1992.

   Chairman, President and

 

   Chief Executive Officer

 

 

 

L. I. Prillaman, 59,

Present position since August 1998; prior thereto was

   Vice Chairman and

   Executive Vice President Marketing.

   Chief Marketing Officer

 

 

 

Stephen C. Tobias, 58,

Present position since August 1998; prior thereto was

   Vice Chairman and

   Executive Vice President Operations.

   Chief Operating Officer

 

 

 

Henry C. Wolf, 60,

Present position since August 1998; prior thereto was

   Vice Chairman and

   Executive Vice President Finance.

   Chief Financial Officer

 

 

 

John F. Corcoran, 62,

Present position since August 1997; prior thereto was

   Senior Vice President

   Vice President Public Affairs

   Public Affairs

 

 

 

John W. Fox, Jr., 55,

Present position since April 2001. Served as Senior Vice

   Senior Vice President

   President Coal Marketing from December 1999 to April 1,

   Coal Services

   2001, and prior thereto was Vice President Coal Marketing.

 

 

James A. Hixon, 49,

Present position since February 2001. Served as Senior Vice

    Senior Vice President

   President Employee Relations from November 1999 to

   Administration

   February 2001, and prior thereto was Vice President

 

   Taxation.

 

 

Henry D. Light, 62,

Present position since January 22, 2002. Served as Vice

   Senior Vice President Law

   President Law from April 2000 to January 22, 2002, and

 

   prior thereto General Counsel Operations.

 

 

James W. McClellan, 63,

Present position since August 1998; prior thereto was Vice

    Senior Vice President Planning

   President Strategic Planning

 

 

Kathryn B. McQuade, 46,

Present position since April 2000. Served as Vice President

   Senior Vice President

   Financial Planning from August 1998 to April 2000, and

   Financial Planning

   prior thereto was Vice President Internal Audit.

 

 

Charles W. Moorman, 51,

Present position since February 1, 2003. Also serves as

   Senior Vice President

   President Thoroughbred Technology and

   Corporate Services

   Telecommunications, Inc. since October 1999, and prior

 

   thereto was Vice President Information Technology.

 

 

John P. Rathbone, 51,

Present position since April 2000; prior thereto was Vice

   Senior Vice President and

   President and Controller

   Controller

 

 

 

Stephen P. Renken, 59,

Present position since February 2001. Served as Vice

   Senior Vice President Chief

   President Information Technology September 1999 to

   Information Officer

   February 2001, Assistant Vice President Program

 

   Management from December 1997 to September 1999, and

 

   prior thereto was a consultant to NS.

 

 

 

 

K13

John M. Samuels, 59,

Present position since April 2000; Served as Vice President

   Senior Vice President

   Operations Planning and Budget from January 1998 to April

   Operations Planning and

   2000; and prior thereto was Vice President Operating Assets

   Support

   of Conrail.

 

 

Donald W. Seale, 50,

Present position since December 1999; prior thereto was Vice

   Senior Vice President

   President Merchandise Marketing.

   Merchandise Marketing

 

 

 

 

 

 

 

 

PART II

 

 

Item 5. Market for Registrant's Common Stock and Related Stockholder Matters.

 

NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES

STOCK PRICE AND DIVIDEND INFORMATION

(Unaudited)

 

The Common Stock of Norfolk Southern Corporation, owned by 51,418 stockholders of record as of Dec. 31, 2002, is traded on the New York Stock Exchange with the symbol NSC. The following table shows the high and low sales prices as reported by Bloomberg L.P. on its internet-based service and dividends per share, by quarter, for 2002 and 2001 (prices quoted in fractions have been rounded to the nearest cent).

 

 

Quarter

2002

 

1st

 

2nd

 

3rd

 

4th

Market price

 

 

 

 

 

 

 

 

   High

$

26.98

$

24.45

$

23.90

$

22.54

   Low

 

18.26

 

19.85

 

17.20

 

18.70

Dividends per share

$

0.06

$

0.06

$

0.07

$

0.07

 

 

 

 

 

 

 

 

 

2001

 

1st

 

2nd

 

3rd

 

4th

Market price

 

 

 

 

 

 

 

 

   High

$

18.90

$

24.11

$

22.60

$

19.88

   Low

 

13.63

 

15.80

 

13.41

 

15.19

Dividends per share

$

0.06

$

0.06

$

0.06

$

0.06

 

 

K14


Item 6. Selected Financial Data.

 

 

NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES

FIVE-YEAR FINANCIAL REVIEW

1998-2002

 

 

2002

2001

2000(1)

1999(2)

1998

 

($ in millions, except per share amounts)

RESULTS OF OPERATIONS

 

 

 

 

 

 

 

 

 

 

Railway operating revenues

$

6,270

$

6,170

$

6,159

$

5,242

$

4,254

Railway operating expenses

 

5,112

 

5,163

 

5,526

 

4,524

 

3,202

   Income from railway operations

 

1,158

 

1,007

 

633

 

718

 

1,052

 

 

 

 

 

 

 

 

 

 

 

Other income – net

 

66

 

99

 

168

 

164

 

309

Interest expense on debt

 

518

 

553

 

551

 

531

 

516

   Income from continuing operations

 

 

 

 

 

 

 

 

 

 

     before income taxes

 

706

 

553

 

250

 

351

 

845

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

246

 

191

 

78

 

112

 

215

   Income from continuing operations

 

460

 

362

 

172

 

239

 

630

 

 

 

 

 

 

 

 

 

 

 

Discontinued operations (3)

 

--

 

13

 

--

 

--

 

104

        Net income

$

460

$

375

$

172

$

239

$

734

 

 

 

 

 

 

 

 

 

 

 

PER SHARE DATA

 

 

 

 

 

 

 

 

 

 

Net income – basic

$

1.18

$

0.97

$

0.45

$

0.63

$

1.94

Net income – diluted

$

1.18

$

0.97

$

0.45

$

0.63

$

1.93

Dividends

$

0.26

$

0.24

$

0.80

$

0.80

$

0.80

Stockholders' equity at year end

$

16.71

$

15.78

$

15.16

$

15.50

$

15.61

 

 

FINANCIAL POSITION

 

 

 

 

 

 

 

 

 

 

Total assets

$

19,956

$

19,418

$

18,976

$

19,250

$

18,180

Total long-term debt, including

 

 

 

 

 

 

 

 

 

 

   current maturities

$

7,364

$

7,632

$

7,636

$

8,059

$

7,624

Stockholders' equity

$

6,500

$

6,090

$

5,824

$

5,932

$

5,921

 

 

 

 

 

 

 

 

 

 

 

OTHER

 

 

 

 

 

 

 

 

 

 

Capital expenditures

$

695

$

746

$

731

$

912

$

1,060

 

 

 

 

 

 

 

 

 

 

 

Average number of shares outstanding

 

 

 

 

 

 

 

 

 

 

   (thousands)

 

388,213

 

385,158

 

383,358

 

380,606

 

378,749

Number of stockholders at year end

 

51,418

 

53,042

 

53,194

 

51,123

 

51,727

Average number of employees:

 

 

 

 

 

 

 

 

 

 

   Rail

 

28,587

 

30,510

 

33,344

 

30,897

 

24,185

   Nonrail

 

383

 

384

 

394

 

269

 

115

      Total

 

28,970

 

30,894

 

33,738

 

31,166

 

24,300

 

 

 

 

 

 

 

 

 

 

 

(1)

2000 operating expenses include $165 million in work-force reduction costs for early retirement and separation programs. These costs reduced net income by $101 million, or 26 cents per diluted share.

(2)

On June 1, 1999, NS began operating a substantial portion of Conrail's properties. As a result, both its railroad route miles and the number of its railroad employees increased by approximately 50% on that date.

(3)

In 1998, NS sold all the common stock of its motor carrier subsidiary, North American Van Lines, Inc. (NAVL), for $207 million and recorded a $90 million pretax ($105 million, or 28 cents per diluted share, after-tax) gain. Accordingly, NAVL's results of operations, financial position and cash flows are presented as "Discontinued operations." Results in 2001 include an additional after-tax gain of $13 million, or 3 cents per diluted share, that resulted from the expiration of certain indemnities contained in the sales agreement.

 

 

K15
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

 

NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES

Management's Discussion and Analysis of

Financial Condition and Results of Operations

 

 

The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes and the Five-Year Financial Review.

 

 

SUMMARIZED RESULTS OF OPERATIONS

 

2002 Compared with 2001

 

Net income was $460 million in 2002, up $85 million, or 23%. Results in 2001 included a $13 million gain from discontinued operations related to the 1998 sale of NS' former motor carrier subsidiary (see Note 17). Excluding that gain from 2001's results, net income was up $98 million, or 27%, in 2002. The improvement was primarily the result of a $151 million, or 15%, increase in income from railway operations.

 

Diluted earnings per share were $1.18, up 22%. Excluding the discontinued operations gain, diluted earnings per share increased 26%.

 

2001 Compared with 2000

 

Net income in 2001 was $375 million, up 118%. Income from continuing operations, which excludes the $13 million discontinued operations gain, was $362 million, up 110%. Results in 2000 included $165 million of costs related to actions taken to reduce the size of the work force, which reduced income from continuing operations by $101 million, or 26 cents per diluted share. Excluding these costs, income from continuing operations increased $89 million, or 33%, in 2001. The improvement resulted from higher income from railway operations, which was up $209 million, or 26%, that more than offset lower nonoperating income, which was down $69 million (see Note 3).

 

Diluted earnings per share were 97 cents, up 116%. Diluted earnings per share from continuing operations were 94 cents, up 109%. Excluding the work-force reduction costs in 2000, diluted earnings per share from continuing operations were up 32%.

 

 

DETAILED RESULTS OF OPERATIONS

 

Railway Operating Revenues

 

Railway operating revenues were $6.3 billion in 2002, and $6.2 billion in both 2001 and 2000. The following table presents a three-year comparison of revenues by market group.

 

 

K16


 


Revenues by Market Group

 

 

 

 

 

 

 

 

2002

2001

2000

 

($ in millions)

Coal

$

1,441

$

1,521

$

1,435

General merchandise:

 

 

 

 

 

 

   Automotive

 

961

 

885

 

921

   Chemicals

 

769

 

752

 

756

   Metals/construction

 

692

 

674

 

689

   Agriculture/consumer products/

 

 

 

 

 

 

      government

 

623

 

603

 

609

   Paper/clay/forest

 

603

 

612

 

630

General merchandise

 

3,648

 

3,526

 

3,605

Intermodal

 

1,181

 

1,123

 

1,119

          Total

$

6,270

$

6,170

$

6,159

 

In 2002, revenues increased 2%, as a 3% rise in general merchandise revenues coupled with a 5% improvement in intermodal revenues offset a 5% decline in coal revenues. All but one of the general merchandise market groups (paper, clay and forest products) posted increases over 2001. As shown in the following table, most of the revenue improvement was the result of higher traffic volumes. The favorable revenue per unit/mix variance was driven by higher average revenue per unit, offset in part by the effects of unfavorable changes in the mix of traffic.

 

Revenue Variance Analysis

Increases (Decreases)

 

 

 

 

2002 vs. 2001

2001 vs. 2000

 

($ in millions)

 

 

 

 

 

Volume

$

89

$

(200)

Revenue per unit/mix

 

11

 

211 

     Total

$

100

$

11 

 

In 2001, revenues fell for all the general merchandise market groups. However, a 6% increase in coal revenues offset the effects of the lower general merchandise revenues. Revenue per unit increased in all market groups, principally due to rate increases, use of higher-capacity equipment and favorable changes in the mix of traffic.

 

COAL tonnage decreased 4% in 2002 and revenues declined 5%. Revenue per unit declined slightly, reflecting unfavorable changes in the mix of traffic (more shorter-haul business) that offset the effects of rate increases and gains in tonnage per car. Coal, coke and iron ore represented 23% of total railway operating revenues in 2002, and 84% of NS' coal shipments originated on lines it operates.

 

In 2001, coal tonnage increased 2%, and revenues improved 6%. Revenue per unit increased 6%, a result of rate increases, including lower volume-related refunds on export coal shipments, gains in tonnage per car and favorable changes in the mix of traffic (less shorter-haul business).

 

 

K17


Total Coal, Coke and Iron Ore Tonnage

 

 

 

 

 

 

 

2002

 

2001

 

2000

 

(In millions of tons)

 

 

 

 

 

 

Utility

128

 

133

 

119

Export

11

 

14

 

20

Domestic metallurgical

21

 

20

 

25

Other

10

 

11

 

11

     Total

170

 

178

 

175

 

Utility coal tonnage decreased 3% in 2002, a result of lower demand that reflected the weak economy, high coal stockpile levels entering the year, mild temperatures in the first quarter, reduced stockpile targets set by utility companies and increased generation from new natural gas-fired plants. Licensing requirements for these new plants resulted in additional generation that temporarily displaced coal-fired generation.

 

In 2001, utility coal traffic increased 11%, reflecting higher demand for coal-fired electricity and the effects of very high natural gas prices early in the year. High demand for coal, a volatile market for natural gas and production problems at a number of large mines in the East late in 2000 combined to increase demand somewhat early in 2001 with a resulting increase in coal prices. Utility coal traffic volume also benefited somewhat from the shifting of coal that traditionally would have been bound for export to the domestic market.

 

Two of NS' utility customers, Duke Energy (Duke) and Carolina Power and Light (CP&L), have filed rate reasonableness complaints at the Surface Transportation Board (STB) alleging that the NS tariff rates for the transportation of coal to their solely served power plants are unreasonable. NS is disputing these allegations. Since January 1, 2002, in the case of Duke and since April 1, 2002, in the case of CP&L, NS has been billing and collecting amounts from the customers based on the challenged tariff rates. Management expects that the resolution of these cases, which is anticipated to occur in 2003, will not have a material effect on NS' financial statements.

 

The near-term outlook for utility coal remains positive. Coal-fired generation remains the lowest cost marginal source of electricity. Coal plant generation should continue to track the U.S. economy, and management expects that utilities will use coal-fired plants to meet increased demand because of coal's low cost. As always, demand will be influenced by the weather. In addition, while the price of natural gas can affect demand for utility coal, its higher price and volatility may improve the long-term competitive position of coal-fired generation.

 

Phase II of Title IV of the Clean Air Act Amendments of 1990, which imposed more stringent limits on sulfur dioxide emissions, took effect on Jan. 1, 2000. Many of the mines served by NS produce coals that satisfy Phase II requirements. In addition, substantial banks of sulfur dioxide allowances held by many NS-served utilities, as well as implementation of sulfur dioxide emission control systems at many NS-served plants, should continue to provide a market for other NS-served mines.

 

While the Phase II impact on NS utility coal has been minimal, there are a number of other evolving environmental issues that have the potential to increase or ease cost pressures on the utility coal market, depending upon their outcome. These include a potential new national energy policy, proposed multi-pollutant legislation, a proposed new rule concerning "new source review," the impending mercury emissions standard and the fate of U.S. participation in the Kyoto Protocol.

 

 

K18


Although impending developments with these environmental issues could potentially increase cost pressures on coal-fired generation, the outlook remains positive for maintaining coal's position in the power generation mix for regions served by NS. However, different developments with these issues could actually ease cost pressures on coal-fired generation, further strengthening coal's position.

 

The 1999 decision by a federal district court judge in West Virginia holding that some common mountaintop mining practices in the coal industry are illegal was overturned in April 2001 by the U.S. Fourth Circuit Court of Appeals. In January 2002, the U.S. Supreme Court refused to hear an appeal of the case. In May 2002, the same district court judge made a similar ruling in a different case in which NS had again intervened. In January 2003, this ruling also was overturned by the Fourth Circuit Court of Appeals.

 

Export coal tonnage declined 18% in 2002. Steam coal exports through Baltimore declined 4%, and export metallurgical coals through Norfolk declined 22%. During the first half of 2002, demand for U.S. coal was soft as international buyers focused their purchases toward other, lower-priced sources. Market uncertainty resulted in late contract settlements and delayed shipments. Late in 2002, demand for U.S. coking coals increased, reflecting a shift in the market as exports from China, Australia and Poland declined. As a result, shipments through Norfolk increased in the fourth quarter.

 

In 2001, export coal tonnage decreased 30%. The rapid rise of domestic utility coal prices early in the year enticed many foreign-market suppliers to place much of their 2001 production in the domestic utility markets. In addition, production difficulties at several large NS-served mines and flooding in West Virginia in July significantly reduced the supply of low volatility coal. The combination of these factors resulted in most of the decline in shipments of export coal. Steam coal exports through Baltimore declined 32%, and export metallurgical coals through Norfolk declined by 30%. Demand for steam coal to export strengthened in the last half of 2001; however, strong U.S. demand limited NS' participation in this market. Demand for coking coal to export continued to soften, as steel production moved from traditional NS markets in Europe to Asia, which in recent years has been supplied by Australian or Canadian coals.

 

It is expected that export coal tonnage will continue to be limited by supply and subject to the fluctuations of the world market. The increase in demand for U.S. coals seen in the fourth quarter of 2002 has continued into the first quarter of 2003, and early indications are that these market forces should remain in place as contracts are settled in the spring for the coming year. Should these market forces continue, U.S. coal export volumes could recover somewhat. However, the inherent volatility and uncertainties in this market make predictions especially vulnerable.

 

Domestic metallurgical coal, coke and iron ore tonnage increased 5% in 2002, reflecting higher U.S. steel production that was aided by the imported steel tariff program implemented in 2002. In addition, continued strong vehicle production resulted in demand for steel.

 

In 2001, domestic metallurgical coal, coke and iron ore tonnage decreased 18% due to a decline in the market for domestic steel. The softening economy and an increase in steel imports drastically cut blast furnace production, sharply reducing the demand for coking coal, iron ore and coke. The increase in imported steel also resulted in lower prices that put pressure on the U.S. steel industry and led to plant closures and bankruptcies that included some NS customers.

 

Domestic metallurgical coal, coke and iron ore traffic is expected to continue to experience modest gains during the two-year life of the import tariffs. However, long-term demand is expected to decline, reflecting advanced technologies that allow production of steel using less coke.

 

 

K19


Other coal tonnage, principally steam coal shipped to manufacturing plants, decreased 14% in 2002, but increased 6% in 2001. The decline in 2002 was primarily the result of the weak economy. The gain in 2001 resulted from new and increased business from industrial customers.

 

GENERAL MERCHANDISE traffic volume (carloads) increased 2% in 2002, and revenues increased 3%, principally due to a 9% improvement in automotive revenues. In 2001, traffic volume decreased 7%, and revenues decreased 2%, reflecting the effects of a weak economy.

 

Automotive traffic volume increased 7%, and revenues increased 9% in 2002, principally due to a rise in vehicle production and new business. Revenue per unit increased 2%, reflecting some pricing improvements, extended length of haul, special ancillary services and the settlement of a disputed charge.

 

In 2001, automotive traffic volume decreased 10%, and revenues declined 4%, principally due to a 10% drop in vehicle production. Revenue per unit increased 7%, principally due to rate increases, efficiencies gained from the redesign of the mixing center network and use of higher capacity equipment.

 

Automotive revenues in 2003 are expected to be lower than those of 2002. Light vehicle production is predicted to be down slightly, and NS' largest automotive customer has announced a 5% decrease in first quarter 2003 production.

 

Chemicals traffic volume increased slightly, and revenues increased 2% in 2002. Higher traffic volume for plastics and a small increase for miscellaneous chemicals offset a decline for petroleum products. Demand for plastics was supported by increases in light vehicle production and housing starts. Traffic volume also benefited from increased shipments through NS' Thoroughbred Bulk Transfer (TBT) facilities that handle chemicals and bulk commodities for customers not located on NS-served lines. Revenue per unit increased as a result of a favorable change in the mix of traffic (more higher-rated business) and market-driven rate increases.

 

In 2001, chemicals traffic volume decreased 5%, and revenues decreased 1%. The weak economy depressed shipments of petroleum, plastics, industrial and miscellaneous chemicals. These declines were partially offset by new business through NS' TBT facilities. Revenue per unit increased due to higher rates and a favorable change in the mix of traffic (more longer-haul moves).

 

Chemicals revenues are expected to improve in 2003, supported by a recovering economy, new business and improved revenue per unit.

 

Metals and construction traffic volume increased 2%, and revenues improved 3% in 2002, reflecting improvement in the steel industry, which was aided by the two-year imported steel tariff program implemented in 2002. Metals volume benefited from resumption of production at some mills that closed in 2001 and increased volume from new mills. Construction traffic declined, primarily as a result of reductions in highway projects due to state government budget pressures.

 

In 2001, metals and construction traffic volume decreased 7%, and revenues declined 2%, reflecting weakness in the steel and construction industries. The steel industry recession, which began in 2000, resulted in excess capacity and the closing of numerous steel mills. Revenue per unit increased due to higher rates and favorable changes in the mix of traffic.

 

Metals and construction revenues are expected to continue to benefit from added production along NS' lines, although further consolidation in the steel industry is expected. Construction markets may benefit from new business from stone quarries and cement terminals in the Southeast.

 

Agriculture, consumer products and government traffic volume decreased slightly in 2002, but revenues increased 3%. Traffic volume increases for corn, food products and beverages largely offset declines for soybeans and feed. Corn volume benefited from increased shipments from the Midwest to

 

 

K20


drought-stricken areas in the East. The increase for food products was primarily the result of new business. Soybean and feed volumes were adversely affected by lower domestic and export demand. Revenue per unit increased because of higher rates, increased length of haul and favorable changes in the mix of traffic.

 

In 2001, agriculture, consumer products and government traffic volume decreased 3%, and revenues declined 1%, primarily due to reduced shipments of fertilizer. This decline was due to soft farm demand, record high natural gas prices early in the year (which curtailed production of certain fertilizers) and increased imports. This was mitigated by traffic volume increases for grain, flour and canned goods. The revenue per unit increase was primarily due to favorable changes in the mix of traffic.

 

Agriculture, consumer products and government revenues in 2003 are expected to continue to benefit from higher corn, fertilizer and food product volume. Fertilizer volumes may be favorably affected by the reopening of a large phosphate fertilizer plant.

 

Paper, clay and forest products traffic volume declined 3%, and revenues decreased 1%, in 2002, primarily due to continued weakness in the paper market, especially in the first half of the year. Traffic volume improved later in the year as the paper market strengthened. In addition, NS gained business from conversion of truck shipments to rail and from continued strength in housing starts. Revenue per unit benefited from rate increases and a decline in shorter-haul business.

 

In 2001, paper, clay and forest products traffic volume declined 8%, and revenues decreased 3%, primarily due to a weakened paper market. Paper shipments were adversely affected by reduced production at many NS-served paper mills, a result of sluggish newspaper advertising and soft demand for paper. Lumber traffic began the year weak, improved in late summer, but softened late in the year due to short-term weakness in housing starts. Revenue per unit increased principally due to higher rates.

 

Paper, clay and forest products revenues are expected to improve slightly in 2003 as a result of a recovering economy, service improvements and new business.

 

INTERMODAL traffic volume increased 6%, and revenues increased 5%, in 2002. Volume growth was principally the result of new and improved services that resulted in new business, including the conversion of truck business to rail. International traffic, which accounts for about half of intermodal volume, increased 10%, supported by growth in trade activity and new business, including the conversion of over-the-road traffic. Domestic shipments grew 6%, primarily because of new business gained from the conversion of truck shipments. Triple Crown Services Company (TCS) volume increased 4%. Revenue per unit declined as a result of an increase in shorter-haul business and the absence of fuel surcharges that were in place in 2001, which were partially offset by some rate increases.

 

In 2001, intermodal traffic volume decreased 1%, but revenues increased slightly. Domestic traffic volume was up in the first half of the year, but demand increasingly weakened as the year progressed, which eroded NS' base of traffic. New business supported by the opening of three new terminals and other initiatives mitigated the effects of the weakened economy. International traffic grew slightly as U.S. imports slowed with the economy. TCS traffic volume increased 1% despite economic conditions, as it continued to provide reliable, trucklike service. Intermodal revenue per unit dropped later in the year, reflecting the expiration of fuel surcharges that were implemented late in 2000 and the introduction of new shorter-haul business.

 

In 2003, intermodal revenues are expected to continue to benefit from new business supported by continued improvements in service and conversion of truck traffic to rail.

 

 

K21


Railway Operating Expenses

 

Railway operating expenses decreased 1% in 2002, while carloads increased 1%. In 2001, railway operating expenses declined 7%. However, expenses in 2000 included $165 million of costs related to actions taken to reduce the size of the work force. Excluding these costs, railway operating expenses decreased 4% in 2001, while carloads dropped 3%.

 

The railway operating ratio, which measures the percentage of railway operating revenues consumed by railway operating expenses, was 81.5% in 2002, compared with 83.7% in 2001 and 87% in 2000 (excluding the work-force reduction costs, which increased the ratio 2.7 percentage points). Both declines primarily resulted from gains in efficiency, although 2002 also benefited from higher traffic volume, and 2001 benefited from increased revenue per unit. The efficiency gains in 2002 were principally the result of the implementation of a new operating plan that emphasizes adherence to a schedule and reductions in service variability. These improvements came despite a continuing change in the mix of traffic (more resource-intensive traffic, such as automotive and intermodal, coupled with the decrease in export coal traffic).

 

The following table shows the changes in railway operating expenses summarized by major classifications.

 

Operating Expense Variances

Increases (Decreases)

 

 

 

 

2002 vs. 2001

2001 vs. 2000

 

($ in millions)

 

 

 

 

 

Compensation and benefits*

$

$

(220)

Materials, services and rents

 

13 

 

(1)

Conrail rents and services

 

(9)

 

(57)

Depreciation

 

 

11 

Diesel fuel

 

(70)

 

(66)

Casualties and other claims

 

28 

 

Other

 

(22)

 

(31)

     Total

$

(51)

$

(363)

 

* Includes $165 million of work-force reduction costs in 2000.

 

Compensation and benefits represented 40% of total railway operating expenses and increased slightly in 2002. Higher wage rates, reduced pension income (see Note 11) and increased health and welfare benefits costs more than offset savings from reduced employment levels and lower payroll taxes (see the discussion of the Railroad Retirement and Survivors' Improvement Act, below). Medical costs are expected to continue to increase in 2003, a result of higher costs for active employees and an increase in the expected inflation related to postretirement benefits.

 

In 2001, compensation and benefits decreased 10%; however, this comparison reflects the $165 million of work-force reduction costs in 2000. Excluding those costs, compensation and benefits decreased 3%, primarily a result of savings attributable to the reduced size of the work force, which were somewhat offset by higher wages and benefit costs for union employees, higher incentive compensation and reduced pension income.

 

The Railroad Retirement and Survivors' Improvement Act, which took effect on Jan. 1, 2002, provides for a phased reduction of the employers' portions of Tier II Railroad Retirement payroll taxes. The phase-in calls for a reduction from 15.6% in 2002 to 14.2% in 2003 and 13.1% in 2004. In addition, the supplemental annuity tax was eliminated. These changes resulted in an estimated $21 million reduction in payroll taxes in 2002 and are expected to result in savings of $20 million in 2003, compared with 2002. However, these

 

 

K22


savings are expected to be offset by an increase in the railroad unemployment tax rate, higher payroll taxes on increased wages and a higher wage base. The new law allows for investment of Tier II assets in a diversified portfolio through the newly established National Railroad Retirement Investment Trust. The law also provides a mechanism for automatic adjustment of future Tier II payroll taxes should the trust assets fall below a four-year reserve or exceed a six-year reserve.

 

Materials, services and rents includes items used for the maintenance of the railroad's lines, structures and equipment; the costs of services purchased from outside contractors, including the net costs of operating joint (or leased) facilities with other railroads; and the net cost of equipment rentals. This category of expenses increased 1% in 2002 and decreased slightly in 2001.

 

The increase in 2002 was the result of higher volume-related expenses for automotive and intermodal traffic, increased material costs for locomotives, higher expenses for roadway and bridge repairs and increased derailment costs. These higher costs were largely offset by a significant reduction in equipment rents. In 2001, the effects of lower equipment rents were largely offset by higher costs for purchased services, including expenses for software, consulting and legal fees.

 

Equipment rents, which includes the cost to NS of using equipment (mostly freight cars) owned by other railroads or private owners, less the rent paid to NS for the use of its equipment, decreased 14% in 2002 and 11% in 2001. The decline in 2002 was principally the result of continued improvement in cycle times, reflecting efficiency gains and, for intermodal equipment, service design and process changes implemented during the year. The decrease in 2001 was primarily due to shorter car cycle times that resulted in fewer car days on line and fewer freight car and locomotive leases.

 

Locomotive repair costs increased in 2002 and 2001, principally due to renewed maintenance activity, which is expected to continue into 2003. Freight car maintenance costs, which were relatively flat in 2002, are also likely to increase in 2003, as it is expected that the economy will recover and more freight cars are due for maintenance.

 

Conrail rents and services decreased 2% in 2002 and 12% in 2001. This item includes amounts due to PRR and CRC for use of their operating properties and equipment and CRC's operation of the Shared Assets Areas. Also included is NS' equity in Conrail's net earnings, plus the additional amortization related to the difference between NS' investment in Conrail and its underlying equity (see Note 2). Both declines reflected higher Conrail earnings and lower expenses in the Shared Assets Areas (see "Conrail's Results of Operations, Financial Condition and Liquidity," below).

 

Depreciation expense was up slightly in 2002 and increased 2% in 2001. Substantial levels of capital spending affected both years; however, depreciation expense in 2002 benefited from lower rates implemented early in the year following completion of a periodic study (see Note 1, "Properties," for NS' depreciation policy).

 

Diesel fuel expenses decreased 17% in 2002 and 14% in 2001. The decline in 2002 reflected a 16% drop in the average price per gallon and slightly lower consumption. Expenses in 2002 included a $10 million benefit from the hedging program initiated in the second quarter of 2001 (see "Market Risks and Hedging Activities," below and Note 16). The decrease in 2001 was the result of an 8% drop in consumption and a 7% decline in the average price per gallon. Expenses in 2001 included $8 million of cost related to the hedging program. NS expects diesel fuel prices to be higher in 2003.

 

Casualties and other claims expenses (including the estimates of costs related to personal injury, property damage and environmental matters) increased 20% in 2002, but only slightly in 2001. The increase in 2002 reflected adverse personal injury claims development as indicated by an actuarial study and higher expenses for loss and damage to lading, as well as higher insurance and environmental remediation costs.

 

 

K23


The largest component of casualties and other claims expense is personal injury costs. In 2002, cases involving occupational injuries comprised about 30% of the total employee injury cases settled and 24% of the total settlement payments made. Injuries of this type are not generally 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 actively employed in the rail industry for decades. NS continues to work actively to eliminate all employee injuries and to reduce the associated costs.

 

The rail industry remains uniquely susceptible to litigation involving job-related accidental injury and occupational claims because of the Federal Employers' Liability Act (FELA), which is applicable only to railroads. This law, which covers employee claims for job-related injuries, produces results that are unpredictable and inconsistent as compared with a no-fault workers' compensation system.

 

NS, like many other businesses in the U.S., has experienced difficulty obtaining property and casualty insurance at reasonable terms since the September 11 terrorist attacks. Thus far, NS has been successful in maintaining a substantial amount of commercial insurance for third-party personal injury, property damage and FELA claims that exceed the self-insured retention. However, both the cost of this commercial insurance and the amount of risk that NS retains through self-insurance has more than doubled since the attacks.

 

Other expenses decreased 10% in 2002 and 13% in 2001. The decline in 2002 reflected lower expenses for property and sales and use taxes. The decrease in 2001 was principally the result of lower bad debt costs, reduced franchise and property taxes, and lower travel and employee-relocation expenses.

 

Other Income – Net

 

Other income – net was $66 million in 2002, $99 million in 2001 and $168 million in 2000 (see Note 3). The decline in 2002 was primarily the result of higher interest accruals on federal income tax liabilities, lower gains from the sale of properties and investments, and the absence of a $13 million gain from a nonrecurring settlement that benefited 2001. These reductions were partially offset by reduced discount from the sales of receivables (due to a lower amount of receivables sold and a lower interest rate environment, which favorably affects the amount of discount). The reduction in 2001 resulted from the absence of $101 million of gains that occurred in 2000 related to the sale of timber rights and gas and oil royalty and working interests. This was somewhat offset by lower interest accruals on federal income tax liabilities and the $13 million nonrecurring settlement gain. Results in 2001 also included an $18 million gain from a large property sale that closed in December.

 

Income Taxes

 

Income tax expense in 2002 was $246 million for an effective rate of 35%, compared with effective rates of 35% in 2001 and 31% in 2000. Excluding the equity in Conrail's after-tax earnings, the effective rates were 38% in 2002 and 2001 and 34% in 2000.

 

The effective rates in 2002 and 2001 were higher than that of 2000, primarily due to dispositions of tax benefits related to coal-seam gas properties. The effective rates in all three years benefited from favorable adjustments upon filing the prior year tax returns and favorable adjustments to state tax liabilities. In addition, 2000 benefited from investments in coal-seam gas properties. The 2003 effective rate may benefit from the resolution of various tax audits.

 

In March 2002, the Job Creation and Worker Assistance Act of 2002 was signed into law and began providing immediate tax incentives for business. A 30% additional first-year depreciation allowance was a primary element of this legislation. This depreciation incentive continues for three years, and during these years the resulting acceleration of tax depreciation deductions will improve cash flow by reducing current tax expense and increasing deferred tax expense by significant amounts.

 

 

K24


Discontinued Operations

 

Income from discontinued operations in 2001 consisted of a $13 million after-tax gain related to the sale of NS' motor carrier subsidiary (see Note 17).

 

 

FINANCIAL CONDITION, LIQUIDITY AND CAPITAL RESOURCES

 

Cash provided by operating activities, NS' principal source of liquidity, was $803 million in 2002, compared with $654 million in 2001 and $1.3 billion in 2000. In 2002, the improvement was the result of higher income from railway operations and favorable changes in working capital, which were offset, in part, by fewer accounts receivable sold (see Note 5). Receivable sales declined $270 million in 2002 and $88 million in 2001. The significant decline in operating cash flow in 2001 reflects the commencement in 2000 of the accounts receivable sales program. Excluding the infusion of cash in 2000 from the start of this program, operating cash flow declined by $300 million in 2001. The decrease primarily resulted from an $88 million reduction in the amount of accounts receivable sold, higher tax payments including amounts applicable to prior years, an increase in telecommunication receivables, bonus payments in 2001 (no such payments in 2000) and the timing of payrolls.

 

A significant portion of payments made to PRR (which are included in "Conrail Rents and Services" and, therefore, are a use of cash in "Cash provided by operating activities") are borrowed back from a PRR subsidiary and, therefore, are a source of cash in "Proceeds from borrowings." NS' net cash flow from these borrowings amounted to $212 million in 2002 and $250 million in 2001.

 

NS' working capital deficit was $554 million at Dec. 31, 2002, compared with $1.3 billion at Dec. 31, 2001. The decline resulted principally from the change in the terms of the note under which NS borrows funds from a subsidiary of PRR (see Note 2) and a reduction in the amount of debt due within one year. Debt due in 2003 is expected to be paid using cash generated from operations (including sales of accounts receivable) and cash on hand.

 

NS currently has the capability to increase the amount of accounts receivable being sold under the revolving sale program to meet its more immediate working capital needs. During 2002, the amount of receivables NS could sell under this program ranged from $368 million to $421 million, and the amount of receivables NS sold ranged from $30 million to $400 million. Moreover, NS has the capability to issue up to $1 billion of commercial paper (see Note 8); however, reductions in its credit ratings could limit NS' ability to access the commercial paper markets (see also the discussion of financing activities, below).

 

NS expects to generate sufficient cash flow from operations to meet its ongoing obligations. This expectation is based on a view that the economy will remain flat for the first half of 2003 and resume growth in the third and fourth quarters.

 

 

K25


Contractual obligations at Dec. 31, 2002, related to NS' long-term debt (including capital leases), operating leases, agreements with CRC, unconditional purchase obligations and other long-term obligations are as follows:

 

 

 

 

2004-

2006-

2008 and

 

Total

2003

2005

2007

Subsequent

 

($ in millions)

 

 

 

 

 

 

 

 

 

 

 

Long-term debt and

 

 

 

 

 

 

 

 

 

 

   capital leases

$

7,364

$

358

$

856

$

1,153

$

4,997

Operating leases

 

880

 

113

 

166

 

115

 

486

Agreements with CRC

 

748

 

30

 

65

 

68

 

585

Unconditional purchase

 

 

 

 

 

 

 

 

 

 

   obligations

 

164

 

164

 

--

 

--

 

--

Other long-term obligations

 

38

 

8

 

16

 

14

 

--

      Total

$

9,194

$

673

$

1,103

$

1,350

$

6,068

 

NS also has contractual obligations to PRR as disclosed in Note 2. However, NS has the ability to borrow back funds from PRR to the extent they are not needed to fund contractual obligations at Conrail. As an indirect owner of Conrail, NS may need to make capital contributions, loans or advances to Conrail to fund its contractual obligations. The following table presents 58% of Conrail's contractual obligations for long-term debt (including capital leases) and operating leases. Conrail has no unconditional purchase or other long-term obligations.

 

 

 

 

2004-

2006-

2008 and

 

Total

2003

2005

2007

Subsequent

 

($ in millions)

 

 

 

 

 

 

 

 

 

 

 

Long-term debt and

 

 

 

 

 

 

 

 

 

 

   capital leases

$

684

$

33

$

62

$

62

$

527

Operating leases

 

327

 

32

 

64

 

62

 

169

      Total

$

1,011

$

65

$

126

$

124

$

696

 

NS also has two transactions not included in the balance sheets or in the previous table of its contractual obligations consisting of an accounts receivable sale program (see Note 5) and an operating lease covering 140 locomotives (see Note 9).

 

Under the accounts receivable sale program, NS sells without recourse undivided ownership interests in a pool of accounts receivable to two unrelated buyers. NS has no ownership interest in the buyers. The buyers issued debt to fund their initial purchase, and NS used the proceeds it received from the initial purchase primarily to pay down its outstanding debt. NS has no obligation related to the buyers' debt, and there is no existing obligation to repurchase sold receivables. Upon termination of the program, the buyers would cease purchasing new receivables and would retain collections related to the previously sold receivables (see Note 5).

 

The operating lease covering the 140 locomotives is renewable annually at NS' option and expires in 2008. The lessor is a special-purpose entity formed to enter into this transaction, but it is not related to NS and its owner has a substantive residual equity capital investment at risk in the entity. The lessor owns the locomotives and issued debt to finance their purchase. NS has no obligation related to the debt. NS has the option to purchase the locomotives, but also can return them to the lessor. The return provisions of the lease are not so onerous as to preclude this option. If NS does not purchase the locomotives at the end of the maximum lease term, it is liable for any shortfall in the then fair value of the locomotives and a specified residual value. NS does not expect to be required to make any payments

 

 

K26


under this provision (see Note 9). As the primary beneficiary of the business of the lessor, effective

Jan. 1, 2003, NS consolidated the assets (locomotives) and liabilities (debt) of this special-purpose entity when it implemented Financial Accounting Standards Board Interpretation No. 46 (see "New Accounting Pronouncement" on page K34).

 

Cash used for investing activities increased 12% in 2002 and 3% in 2001. Property additions, which account for most of the recurring spending in this category, were down 8% in 2002, following a 2% increase in 2001. Property sales were significantly lower in 2002, which resulted in the net increase in cash used for investing activities despite the reduction in capital spending. The following tables show capital spending (including capital leases) and track and equipment statistics for the past five years.

 

Capital Expenditures

 

 

 

 

 

 

 

2002

2001

2000

1999

1998

 

($ in millions)

 

 

 

 

 

 

 

 

 

 

 

Road

$

519

$

505

$

557

$

559

$

612

Equipment

 

174

 

233

 

146

 

349

 

442

Other property

 

2

 

8

 

28

 

4

 

6

      Total

$

695

$

746

$

731

$

912

$

1,060

 

Capital expenditures (which in 2002 included $6 million of capitalized leases) decreased 7% in 2002, but increased 2% in 2001. The decline in 2002 reflected lower spending for intermodal facilities, as NS completed in 2001 several significant projects that expanded the capacity of the intermodal network. Higher spending on track program work was offset by fewer locomotive purchases (50 in 2002 compared with 100 in 2001). Outlays in 2001 included amounts for locomotive purchases (no such purchases were made in 2000 as locomotives were leased) that were somewhat offset by lower expenditures for freight car purchases and roadway projects. In 2002, 2001 and 2000, spending for road included fiber-optic infrastructure (see "Telecommunications Subsidiary," below).

 


Track Structure Statistics (Capital and Maintenance)

 

 

 

 

 

 

 

2002

2001

2000

1999

1998

 

 

 

 

 

 

 

 

 

 

 

Track miles of rail installed

 

235

 

254

 

390

 

403

 

429

Miles of track surfaced

 

5,270

 

3,836

 

3,687

 

5,087

 

4,715

New crossties installed (millions)

 

2.8

 

1.5

 

1.5

 

2.3

 

2.0

 

 

Average Age of Owned Railway Equipment

 

 

 

 

 

 

 

2002

2001

2000

1999

1998

 

 

 

 

 

(years)   

 

 

 

Freight cars

 

25.9

 

25.4

 

24.6

 

23.8

 

23.6

Locomotives

 

16.1

 

15.7

 

16.1

 

15.4

 

15.4

Retired locomotives

 

28.2

 

22.4

 

24.5

 

22.7

 

20.6

 

The table above excludes equipment leased from PRR (see Note 2), which comprises 17% of the freight car fleet and 25% of the locomotive fleet.

 

Through its coal car rebody program, which was suspended in 2000, NS converted about 29,000 hopper cars into high-capacity steel gondolas or hoppers. As a result, the remaining service life of the freight-car fleet is greater than may be inferred from the increasing average age shown in the table above.

 

 

K27


For 2003, NS has budgeted $798 million for capital expenditures. The anticipated spending includes $499 million for roadway projects, of which $383 million is for track and bridge program work. Also included are projects for communications, signal and electrical systems, as well as projects for environmental and public improvements such as grade crossing separations and signal upgrades. Other roadway projects include marketing and industrial development initiatives, including increasing track capacity and access to coal receivers and vehicle production and distribution facilities, and continuing investments in intermodal infrastructure. Equipment spending of $246 million includes the purchase of 100 locomotives and upgrades to existing units, improvements to multilevel automobile racks, and projects related to computers and information technology, including additional security and backup systems.

 

Cash used for financing activities in 2002 was $150 million. Financing activities provided cash of $151 million in 2001 and used cash of $798 million in 2000. The comparisons reflect a net reduction of debt in 2002, a net increase in 2001 and a net reduction in 2000. The comparison in 2001 also reflected the effects of the reduction to the dividend in January 2001. Financing activities include loan transactions with a subsidiary of PRR that resulted in net borrowings of $212 million in 2002 and $250 million in 2001 and net repayments of $72 million in 2000 (see Note 2). Excluding these borrowings, debt was reduced $303 million in 2002, $20 million in 2001 and $422 million in 2000. The net reduction of debt in 2000 was accomplished in part with the proceeds from the sale of accounts receivable. NS' debt-to-total capitalization ratio (excluding notes payable to the PRR subsidiary) at year end was 53.1% in 2002 and 55.6% in 2001.

 

NS currently has in place a $1 billion, five-year credit agreement, which provides for borrowings at prevailing rates and includes financial covenants (see Note 8).

 

NS has outstanding $717 million of its 7.05% notes due May 1, 2037. Each holder of a 2037 note may require NS to redeem all or part of the note at face value, plus accrued and unpaid interest, on May 1, 2004. NS will not know the amount of 2037 notes that it may be required to redeem until April 1, 2004. NS expects to be able to redeem any such notes using cash generated from operations (including sales of accounts receivable), cash on hand and proceeds from borrowings.

 

 

APPLICATION OF CRITICAL ACCOUNTING ESTIMATES

 

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates and assumptions may require significant judgment about matters that are inherently uncertain, and future events are likely to occur that may require management to change them. Accordingly, management regularly reviews these estimates and assumptions based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances. Management discusses the development, selection and disclosures concerning critical accounting estimates with the Audit Committee of its Board of Directors.

 

Pensions and Other Postretirement Benefits

 

Accounting for pensions and other postretirement benefit plans requires management to make several estimates and assumptions (see Note 11). These include the expected rate of return from investment of the plans' assets, projected increases in medical costs and the expected retirement age of employees as well as their projected earnings and mortality. In addition, the amounts recorded are affected by changes in the interest rate environment because the associated liabilities are discounted to their present value. Management makes these estimates based on the company's historical experience and other information that it deems pertinent under the circumstances (for example, expectations of future stock market performance). Management engages an independent consulting actuarial firm to aid it in selecting appropriate assumptions and valuing its related liabilities.

 

 

K28


NS' net pension benefit, which is included in "Compensation and benefits" on its Consolidated Income Statement, was $79 million for the year ended Dec. 31, 2002. In recording this amount, NS assumed a long-term investment rate of return of 9%, compared with the 10% rate used in the previous two years. Investment experience of the pension fund over the past 10-, 15- and 20-year periods has been in excess of 10%. A one percentage point change to this rate of return assumption would result in a $20 million change to the pension credit and, as a result, an equal change in "Compensation and benefits" expense. Changes that are reasonably likely to occur in assumptions concerning retirement age, projected earnings and mortality would not be expected to have a material effect on NS' net pension benefit or net pension asset in the future. The net pension asset is recorded at its net present value using a discount rate that is based on the current interest rate environment; therefore, management has little discretion in this assumption.

 

NS' net cost for other postretirement benefits, which is also included in "Compensation and benefits," was $34 million for the year ended Dec. 31, 2002. In recording this expense and valuing the net liability for other postretirement benefits, which is included in "Other benefits" as disclosed in Note 11, management estimated future increases in health-care costs. These assumptions, along with the effect of a one percentage point change in them, are described in Note 11.

 

Properties and Depreciation

 

Most of NS' total assets are comprised of long-lived railway properties (see Note 6) and its investment in Conrail (see Note 2). Most of Conrail's assets are long-lived railway properties. As disclosed in Note 1, NS' properties are depreciated using group depreciation. Rail is depreciated primarily on the basis of use measured by gross-ton miles. Other properties are depreciated generally using the straight-line method over the lesser of estimated service or lease lives. NS reviews the carrying amount of properties whenever events or changes in circumstances indicate that such carrying amount may not be recoverable based on future undiscounted cash flows or estimated net realizable value. Assets that are deemed impaired as a result of such review are recorded at the lesser of carrying amount or fair value. NS is amortizing the excess of the purchase price paid for its investment in Conrail over its share of Conrail's net equity using the principles of purchase accounting, based primarily on the estimated remaining useful lives of Conrail's properties.

 

NS' depreciation expense is based on management's assumptions concerning service lives of its properties as well as the expected net salvage that will be received upon their retirement. These assumptions are the product of periodic depreciation studies that are performed by a firm of consulting engineers. These studies analyze NS' historical patterns of asset use and retirement and take into account any expected change in operation or maintenance practices. NS' recent experience with these studies has been that while they do result in changes in the rates used to depreciate its properties, these changes have not caused a significant effect to its annual depreciation expense. The studies may also indicate that the recorded amount of accumulated depreciation is deficient (or in excess) of the amount indicated by the study. Any such deficiency (or excess) is amortized as a component of depreciation expense over the remaining service lives of the affected class of property. NS' "Depreciation expense" for the year ended Dec. 31, 2002, amounted to $515 million. NS' weighted-average depreciation rates for 2002 are disclosed in Note 6; a one-tenth percentage point increase (or decrease) in these rates would result in a $17 million increase (or decrease) to NS' depreciation expense.

 

Personal Injury, Environmental and Legal Liabilities

 

NS' expense for "Casualties and other claims" amounted to $171 million for the year ended Dec. 31, 2002. Most of this expense was composed of NS' accrual related to personal injury liabilities (see discussion of FELA in the discussion captioned "Casualties and other claims" on page K23). NS engages an independent consulting actuarial firm to aid in valuing its personal injury liability and determining the amount to accrue during the year. The actuarial firm studies NS' historical patterns of reserving for claims and subsequent settlements. The actuary also takes into account outside influences considered pertinent. The study uses the results of these analyses to estimate the ultimate amount of the liability, which includes amounts for incurred but unasserted claims. NS has recorded this actuarially determined liability. The liability is dependent upon many individual judgments made as to the specific case reserves as well as the judgments of the consulting

 

 

K29


actuary and management in the periodic studies. Accordingly, there could be significant changes in the liability, which NS would recognize when such a change became known. The most recent actuarial study was performed as of June 30, 2002, and resulted in an increase to NS' personal injury liability during the third quarter. While the liability recorded is supported by the most recent study, it is reasonably possible that the liability could be higher or lower.

 

NS is subject to various jurisdictions' environmental laws and regulations.  It is NS' policy to record a liability where such liability or loss is probable and its amount can be estimated reasonably (see Note 18). Environmental engineers regularly participate in ongoing evaluations of all known sites and in determining any necessary adjustments to liability estimates. NS also has established an Environmental Policy Council, composed of senior managers, to oversee and interpret its environmental policy.

 

Operating expenses for environmental matters totaled approximately $15 million in 2002, $12 million in 2001, and $11 million in 2000, and capital expenditures totaled approximately $10 million in each of 2002, 2001 and 2000. Capital expenditures in 2003 are expected to be comparable to those in 2002.

 

NS' balance sheets included liabilities for environmental exposures in the amount of $29 million at Dec. 31, 2002, and $33 million at Dec. 31, 2001 (of which $8 million was accounted for as a current liability in each year). At Dec. 31, 2002, the liability represented NS' estimate of the probable cleanup and remediation costs based on available information at 114 identified locations. On that date, 10 sites accounted for $16 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 114 locations, certain NS subsidiaries, usually in conjunction with a number of other parties, have been identified as potentially responsible parties by the Environmental Protection Agency (EPA) or similar state authorities under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, or comparable state statutes, which often impose joint and several liability for cleanup costs.

 

With respect to known environmental sites (whether identified by NS or by the EPA or comparable state authorities), estimates of NS' ultimate potential financial exposure for a given site or in the aggregate for all such sites are necessarily imprecise because of the widely varying costs of currently available cleanup techniques, the likely development of new cleanup technologies, the difficulty of determining in advance the nature and full extent of contamination and each potential participant's share of any estimated loss (and that participant's ability to bear it), and evolving statutory and regulatory standards governing liability. NS estimates its environmental remediation liability on a site-by-site basis, using assumptions and judgments that management deems appropriate for each site. As a result, it is not practical to quantitatively discuss the effects of changes in these many assumptions and judgments. NS has consistently applied its methodology of estimating its environmental liabilities.

 

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 or may have been 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 environmentally related 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 now-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 Corporation is aware.  Further, management believes that it is unlikely that any known matters, either individually or in the aggregate, will have a material adverse effect on NS' financial position, results of operations or liquidity.

 

 

 

K30


Norfolk Southern and certain subsidiaries are defendants in numerous lawsuits and other claims relating principally to railroad operations.  When management concludes that it is probable that a liability has been incurred and the amount of the liability can be reasonably estimated, it is accrued through a charge to expenses.  While the ultimate amount of liability incurred in any of these lawsuits and claims is dependent on future developments, in management's opinion the recorded liability, if any, is adequate to cover the future payment of such liability and claims.  However, the final outcome of any of these lawsuits and claims cannot be predicted with certainty, and unfavorable or unexpected outcomes could result in additional accruals that could be significant to results of operations in a particular year or quarter.  Any adjustments to recorded liability will be reflected in expenses in the periods in which such adjustments are known.

 

Income Taxes

 

NS' net deferred tax liability totaled $3,010 million at Dec. 31, 2002 (see Note 4). This liability is estimated based on the expected future tax consequences of items recognized in the financial statements. After application of the federal statutory tax rate to book income, judgment is required with respect to the timing and deductibility of expenses in the corporate income tax returns. For state income and other taxes, judgment is also required with respect to the apportionment among the various jurisdictions. A valuation allowance is recorded if management expects that it is more likely than not that its deferred tax assets will not be realized. NS has only a $24 million valuation allowance on $592 million of deferred tax assets as of Dec. 31, 2002, reflecting the expectation that most of these assets will be realized. For 2002, 2001 and 2000, the effective tax rates, excluding NS' equity in Conrail's earnings, were 38%, 38% and 34%, respectively. For every 1/2% change in the 2002 effective tax rate, net income would have changed by $4 million.

 

 

CONRAIL'S RESULTS OF OPERATIONS, FINANCIAL CONDITION AND LIQUIDITY

 

Conrail's net income was $180 million in 2002, compared with $174 million in 2001 and $170 million in 2000 (see Note 2). The increase in 2002 was primarily the result of a favorable federal tax settlement. The improvement in 2001 reflected lower casualties and other claims expenses, a favorable adjustment to state income tax reserves and environmental and insurance settlements in Conrail's favor. These positive items were offset in part by the absence of significant gains from the sale of property.

 

Conrail's operating revenues were $893 million in 2002, $903 million in 2001 and $985 million in 2000. Both decreases resulted from the expiration of certain equipment leases and lower operating fees, largely because of reduced operating costs in the Shared Assets Areas. The decline in 2001 also reflected lower revenues at Conrail's Indiana Harbor Belt subsidiary.

 

Conrail's operating expenses were $623 million in 2002, $639 million in 2001 and $749 million in 2000. The decrease in 2002 reflected lower expenses for materials, services and rents and compensation and benefits, which were offset, in part, by higher costs for casualties and other claims. The decline in 2001 was primarily due to lower expenses for materials, services and rents; casualties and other claims; and compensation and benefits.

 

Conrail's cash provided by operations decreased $79 million, or 16%, in 2002, and increased $140 million, or 39%, in 2001. The decline in 2002 was primarily the result of the absence of two items that benefited 2001: a $50 million cash payment for transferring to a third party certain rights to license, manage and market signboard advertising on Conrail's property for 25 years and proceeds from a favorable insurance settlement. This was offset, in part, by favorable changes in working capital. The increase in 2001 was largely the result of the two unusual items discussed above. Cash generated from operations is Conrail's principal source of liquidity and is primarily used for debt repayments and capital expenditures. Debt repayments totaled $59 million in 2002 and $61 million in 2001. Capital expenditures totaled $23 million in 2002 and $47 million in 2001.

 

 

K31


Conrail had a working capital deficit of $29 million at Dec. 31, 2002, compared with working capital of $438 million at Dec. 31, 2001, which included $687 million of amounts receivable from NS and CSX. Conrail is not an SEC registrant and, therefore, presently cannot issue any publicly traded securities. Conrail is expected to have sufficient cash flow to meet its ongoing obligations.

 

NS' equity in earnings of Conrail, net of amortization, was $54 million in 2002, $44 million in 2001 and $21 million in 2000. NS' other comprehensive loss for 2002 and 2001, as shown in the Consolidated Statement of Changes in Stockholders' Equity, included $34 million and $41 million, respectively, for its portion of Conrail's other comprehensive loss (see Note 13).

 

 

OTHER MATTERS

 

Telecommunications Subsidiary

 

NS' subsidiary, Thoroughbred Technology and Telecommunications, Inc. (T-Cubed), has developed fiber optic infrastructure with members of the telecommunications industry. This industry has experienced a severe downturn. As a result of changes in the values of telecommunications assets, T-Cubed is monitoring its carrying amount of these assets, as required by SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets." To date, based on known facts and circumstances, management believes that its ultimate investment in these assets will be recovered, and accordingly, no impairment has been recognized (see Note 6).

 

During 2001, one of T-Cubed's codevelopers, 360networks (USA),inc. ("360"), filed for protection under Chapter 11 of the U.S. Bankruptcy Code and foreign laws. 360 owes T-Cubed amounts for work performed on certain joint projects; and T-Cubed owes 360 amounts for work performed on other joint projects. The bankruptcy judge has approved set-off of these amounts, leaving about $7 million due to T-Cubed from 360. T-Cubed has the right to collect this amount from any proceeds due 360 from the sale of joint assets. Management believes that it will collect this receivable.

 

T-Cubed is engaged in contract litigation with a second codeveloper, Williams Communications, LLC ("Williams Communications"), concerning the latter's obligation to purchase fiber optic infrastructure installed by T-Cubed between Cleveland, Ohio, and northern Virginia. On Jan. 29, 2003, the United States District Court for the Northern District of Georgia entered an order requiring Williams Communications to pay T-Cubed the remaining amount due for such infrastructure, approximately $36 million, plus prejudgment interest at a rate of 9% per annum. Williams Communications may elect to appeal. The ability to collect and retain a judgment against Williams Communications may be limited due to its financial condition; however, the shortfall, if any, cannot now be determined. Its parent, Williams Communications Group, Inc., filed in April 2002 a voluntary petition for reorganization under Chapter 11 of the U.S. Bankruptcy Code, and emerged from bankruptcy in October 2002. Williams Communications was not included in the bankruptcy petition (see Note 18).

 

Labor Arbitration

 

Several hundred claims have been filed with NSR on behalf of employees furloughed after June 1, 1999, for various periods of time, alleging that the furloughs were a result of the Conrail transaction and seeking "New York Dock" income protection benefits. Several labor organizations have initiated arbitration on behalf of individual employees. Other disputes are pending wherein similar benefits are sought under labor agreement provisions that, in management's judgment, do not apply to the involved circumstances.

 

Based on known facts, including the availability of legal defenses, management believes that NS will prevail in these disputes and that any potential liability for the involved claims should not have a material adverse effect on NS' financial position, results of operations or liquidity. Depending on the outcome of these arbitrations, additional claims may be filed or progressed to arbitration. Should all such claimants prevail, there could be a significant effect on results of operations in a particular quarter (see Note 18).

 

 

K32


Labor Agreements

 

Approximately 24,000 of NS' railroad employees are covered by collective bargaining agreements with 15 different labor unions. These agreements remain in effect until changed pursuant to the Railway Labor Act. Moratorium provisions in these agreements permitted NS and the unions to propose such changes in late 1999; negotiations at the national level commenced shortly thereafter. The outcome of these negotiations is uncertain at this time. However, agreements have been reached with the Brotherhood of Maintenance of Way Employes (BMWE), which represents about 4,200 NS employees; the Brotherhood of Locomotive Engineers (BLE), which represents about 4,500 NS employees; the United Transportation Union (UTU), which represents about 6,700 NS employees; the International Brotherhood of Boilermakers and Blacksmiths (IBB), which represents about 100 NS employees; and the Transportation Communications International Union (TCU), which represents about 4,400 NS employees. Health and welfare issues have been resolved with BMWE and TCU. The UTU agreement provides that, subsequent to a further period of negotiation, health and welfare issues may be submitted to arbitration. Health and welfare issues with the other organizations have not yet been resolved.

 

Market Risks and Hedging Activities

 

NS uses derivative financial instruments to reduce the risk of volatility in its diesel fuel costs and to manage its overall exposure to fluctuations in interest rates.

 

In 2001, NS began a program to hedge a portion of its diesel fuel consumption. The intent of the program is to assist in the management of NS' aggregate risk exposure to fuel price fluctuations, which can significantly affect NS' operating margins and profitability, through the use of one or more types of derivative instruments.

 

Diesel fuel costs represented 7% of NS' operating expenses for 2002. The program provides that NS will not enter into any fuel hedges with a duration of more than 36 months, and that no more than 80% of NS' average monthly fuel consumption will be hedged for any month within any 36-month period.

 

As of Dec. 31, 2002, through swap transactions, NS has hedged approximately 62% of expected 2003 diesel fuel requirements. The effect of the hedges is to yield an average cost of 73 cents per hedged gallon, including federal taxes and transportation. A 10% decrease in diesel fuel prices would reduce NS' asset related to the swaps by approximately $30 million as of Dec. 31, 2002.

 

NS manages its overall exposure to fluctuations in interest rates by issuing both fixed- and floating-rate debt instruments and by entering into interest-rate hedging transactions to achieve an appropriate mix within its debt portfolio.

 

At Dec. 31, 2002, NS' debt subject to interest rate fluctuations totaled $784 million (excluding debt due to the PRR subsidiary). A 1% increase in interest rates would increase NS' total annual interest expense related to all its variable debt by approximately $8 million. Management considers it unlikely that interest rate fluctuations applicable to these instruments will result in a material adverse effect on NS' financial position, results of operations or liquidity.

 

Some of NS' capital leases, which carry an average fixed rate of 7%, were effectively converted to variable rate obligations using interest rate swap agreements. On Dec. 31, 2002, the average pay rate under these agreements was 2.1%, and the average receive rate was 7%. During 2002, the effect of the swaps was to reduce interest expense by $9 million. A portion of the lease obligations is payable in Japanese yen. NS eliminated the associated exchange rate risk at the inception of each lease with a yen deposit sufficient to fund the yen-denominated obligation. Most of these deposits are held by foreign banks, primarily Japanese. As a result, NS is exposed to financial market risk relative to Japan. Counterparties to the interest rate swaps and Japanese banks holding yen deposits are major financial institutions believed by management to be creditworthy.

 

 

K33


New Accounting Pronouncements

 

The Financial Accounting Standards Board (FASB) has issued Statement No. 143, "Accounting for Asset Retirement Obligations," (SFAS No. 143) which is effective Jan. 1, 2003, and addresses legal obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. In accordance with the Uniform System of Accounts for Railroad Companies (see Code of Federal Regulations, Title 49, Subtitle B, Chapter X, Part 1201), NS depreciates track structure (rail, other track material and ties) to its net salvage value (gross salvage less cost to remove). SFAS No. 143 prohibits the accrual of a liability for removal costs absent a legal obligation to remove the related asset. Management believes that there is no such legal obligation to remove track. The SEC staff has recently taken a position with a registrant in another industry that calls into question whether the use of net salvage that results in depreciating more than the cost basis of an asset (negative salvage) is appropriate once SFAS No. 143 becomes effective. NS is in the process of studying its track accounts to determine where current depreciation rates will result in negative salvage. To the extent that NS' accumulated depreciation includes such amounts, they will be removed. The cumulative effect of this catch-up adjustment will be recorded as a change in accounting principle in the first quarter of 2003. Going forward, this change will result in lower depreciation expense (because the depreciation rate will no longer reflect any negative salvage) and higher compensation and benefits expenses (for the labor cost to remove retired assets); NS does not expect that this will result in a material change to its total railway operating expenses.

 

The FASB has issued Interpretation No. 46, "Consolidation of Variable Interest Entities," (FIN No. 46), which addresses consolidation of certain variable interest entities (also commonly referred to as "special purpose entities"). NS adopted FIN No. 46, effective Jan 1, 2003. As a result, on that date NS consolidated a special-purpose entity that leases certain locomotives to NS (see Note 9). This entity has no other significant assets or liabilities other than the locomotives and the debt related to their purchase, which will be reflected on NS' Consolidated Balance Sheet in 2003. This change in reporting will also have the following effects to NS' Consolidated Income Statement beginning in 2003: operating lease expense will decline, and depreciation expense and interest expense on debt will increase. The net effect of these income statement changes is not significant. Adoption of FIN No. 46 did not have a significant effect on NS' financial position or liquidity.

 

Inflation

 

Generally accepted accounting principles require the use of historical cost in preparing financial statements. This approach 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.

 

Trends

 

Federal Economic Regulation -- Efforts may be made in 2003 to reimpose unwarranted federal economic regulation on the rail industry. The Staggers Rail Act of 1980, which substantially reduced such regulation, encouraged and enabled rail carriers to innovate and to compete for business. NS and other rail carriers will oppose any efforts to reimpose unwarranted economic regulation.

 

Utility Deregulation -- Deregulation of the electrical utility industry is expected to increase competition among electric power generators; deregulation over time would permit wholesalers and possibly retailers of electric power to sell or purchase increasing quantities of power to or from distant parties. The effects of deregulation on NS and on its customers cannot be predicted with certainty; however, NS serves a number of efficient power producers who are expected to remain competitive in this evolving environment.

 

Carbon-Based Fuel -- There is growing concern in some quarters that emissions resulting from burning carbon-based fuel, including coal, are contributing to global warming and causing other environmental changes. To the extent that these concerns evolve into a consensus among policy-makers, the impact could be

 

 

K34


either a reduction in the demand for coal or imposition of more stringent regulations on emissions, which might result in making coal a less economical source of power generation or make permitting of coal-fired facilities even more difficult. The revenues and net income of NSR and other railroads that move large quantities of coal could be affected adversely.

 

 

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; the business environment in industries that produce and consume rail freight; competition and consolidation within the transportation industry; fluctuation in prices of key materials, in particular diesel fuel; labor difficulties, including strikes and work stoppages; legislative and regulatory developments; changes in securities and capital markets; and natural events such as severe weather, floods and earthquakes. Forward-looking statements are not, and should not be relied upon as, a guaranty of future performance or results. Nor will they necessarily prove to be accurate indications of the times at or by which any such performance or results will be achieved. As a result, actual outcomes and results may differ materially from those expressed in forward-looking statements. The Company undertakes no obligation to update or revise forward-looking statements.

 

 

Item 7A. Quantitative and Qualitative Disclosures about Market Risk.

 

The information required by this item is included in Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the heading "Market Risks and Hedging Activities."

 

 

K35


Item 8. Financial Statements and Supplementary Data.

 

 

INDEX TO FINANCIAL STATEMENTS

 

 

 

Page

 

 

   Report of Management

K37

 

 

   Independent Auditors' Report

K38

 

 

   Independent Accountants' Report on Internal Control over Financial Reporting

K38

 

 

   Consolidated Statements of Income

K39

   Years ended December 31, 2002, 2001 and 2000

 

 

 

   Consolidated Balance Sheets

K40

   As of December 31, 2002 and 2001

 

 

 

   Consolidated Statements of Cash Flows

K41

   Years ended December 31, 2002, 2001 and 2000

 

 

 

   Consolidated Statements of Changes in Stockholders' Equity

K42

   Years ended December 31, 2002, 2001 and 2000

 

 

 

   Notes to Consolidated Financial Statements

K43

 

 

   The Index to Consolidated Financial Statement Schedule in Item 15

K70

 

 

K36


Report of Management

 

 

January 28, 2003

 

To the Stockholders

Norfolk Southern Corporation

 

Management is responsible for the preparation and fair presentation of the financial statements included in this annual report. The financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America and reflect management's judgments and estimates concerning effects of events and transactions that are accounted for or disclosed.

 

Management is also responsible for establishing and maintaining effective internal control over financial reporting. The Corporation's internal control over financial reporting includes those policies and procedures that pertain to the Corporation's ability to record, process, summarize and report reliable financial data. Management recognizes that there are inherent limitations in the effectiveness of any internal control over financial reporting, including the possibility of human error and the circumvention or overriding of internal control. Accordingly, even effective internal control over financial reporting can provide only reasonable assurance with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control over financial reporting may vary over time.

 

In order to ensure that the Corporation's internal control over financial reporting is effective, management regularly assesses such controls and did so most recently for its financial reporting as of December 31, 2002. This assessment was based on criteria for effective internal control over financial reporting described in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this assessment, management believes the Corporation maintained effective internal control over financial reporting as of December 31, 2002.

 

The Board of Directors, acting through its Audit Committee, is responsible for the oversight of the Corporation's accounting policies, financial reporting and internal control. The Audit Committee of the Board of Directors is comprised entirely of outside directors who are independent of management. The Audit Committee is responsible for the appointment and compensation of the independent auditor, and approves decisions regarding the appointment or removal of the Vice President-Internal Audit. It meets periodically with management, the independent auditors, and the internal auditors to ensure that they are carrying out their responsibilities. The Audit Committee is also responsible for performing an oversight role by reviewing and monitoring the financial, accounting and auditing procedures of the Corporation in addition to reviewing the Corporation's financial reports. The independent auditors and the internal auditors have full and unlimited access to the Audit Committee, with or without management, to discuss the adequacy of internal control over financial reporting, and any other matters which they believe should be brought to the attention of the Audit Committee.

 

KPMG LLP, independent auditors of the Corporation's financial statements, has reported on management's assertion with respect to the effectiveness of the Corporation's internal control over financial reporting as of December 31, 2002.

 

 

 

/s/ David R. Goode

/s/ Henry C. Wolf

/s/ John P. Rathbone

David R. Goode

Henry C. Wolf

John P. Rathbone

Chairman, President and

Vice Chairman and

Senior Vice President and

Chief Executive Officer

Chief Financial Officer

Controller

 

 

K37
Independent Auditors' Report

 

The Stockholders and Board of Directors

Norfolk Southern Corporation:

We have audited the accompanying consolidated balance sheets of Norfolk Southern Corporation and subsidiaries as of December 31, 2002 and 2001, and the related consolidated statements of income, changes in stockholders' equity and cash flows for each of the years in the three-year period ended December 31, 2002. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule as listed in Item 15(A)2. These consolidated financial statements and financial statement schedule are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Norfolk Southern Corporation and subsidiaries as of December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002 in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

/s/ KPMG LLP 

Norfolk, Virginia

January 28, 2003

 

 

INDEPENDENT ACCOUNTANTS' REPORT ON INTERNAL CONTROL

OVER FINANCIAL REPORTING

 

The Board of Directors

Norfolk Southern Corporation:

We have examined management's assertion, included in the accompanying Report of Management, that Norfolk Southern Corporation maintained effective internal control over financial reporting as of December 31, 2002 based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Norfolk Southern Corporation's management is responsible for maintaining effective internal control over financial reporting. Our responsibility is to express an opinion on management's assertion based on our examination.

Our examination was conducted in accordance with attestation standards established by the American Institute of Certified Public Accountants and, accordingly, included obtaining an understanding of the internal control over financial reporting, testing, and evaluating the design and operating effectiveness of the internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our examination provides a reasonable basis for our opinion.

Because of inherent limitations in any internal control, misstatements due to error or fraud may occur and not be detected. Also, projections of any evaluation of the internal control over financial reporting to future periods are subject to the risk that the internal control may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management's assertion that Norfolk Southern Corporation maintained effective internal control over financial reporting as of December 31, 2002 is fairly stated, in all material respects, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

 

/s/ KPMG LLP 

Norfolk, Virginia

January 28, 2003

 

 

 

K38
Norfolk Southern Corporation And Subsidiaries

Consolidated Statements of Income

 

 

Years ended December 31,

 

2002

2001

2000

 

($ in millions, except earnings per share)

 

 

 

 

 

 

 

Railway operating revenues

$

6,270 

$

6,170 

$

6,159 

 

 

 

 

 

 

 

Railway operating expenses

 

 

 

 

 

 

  Compensation and benefits (Note 11)

 

2,022 

 

2,014 

 

2,234 

  Materials, services and rents

 

1,457 

 

1,444 

 

1,445 

  Conrail rents and services (Note 2)

 

412 

 

421 

 

478 

  Depreciation

 

515 

 

514 

 

503 

  Diesel fuel

 

342 

 

412 

 

478 

  Casualties and other claims

 

171 

 

143 

 

142 

  Other

 

193 

 

215 

 

246 

 

 

 

 

 

 

 

    Total railway operating expenses

 

5,112 

 

5,163 

 

5,526 

 

 

 

 

 

 

 

    Income from railway operations

 

1,158 

 

1,007 

 

633 

 

 

 

 

 

 

 

Other income – net (Note 3)

 

66 

 

99 

 

168 

Interest expense on debt (Note 6)

 

(518)

 

(553)

 

(551)

 

 

 

 

 

 

 

    Income from continuing operations

 

 

 

 

 

 

      before income taxes

 

706 

 

553 

 

250 

 

 

 

 

 

 

 

Provision for income taxes (Note 4)

 

246 

 

191 

 

78 

 

 

 

 

 

 

 

    Income from continuing operations

 

460 

 

362 

 

172 

 

 

 

 

 

 

 

Discontinued operations – gain on sale

 

 

 

 

 

 

  of motor carrier, net of taxes (Note 17)

 

-- 

 

13 

 

-- 

 

 

 

 

 

 

 

    Net income

$

460 

$

375 

$

172 

 

 

 

 

 

 

 

Earnings per share (Note 14)

 

 

 

 

 

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