NSC

Norfolk Southern Corp. 10-Q Summary

Business Context and Reporting Period

This filing is a Quarterly Report (Form 10-Q) for Norfolk Southern Corporation (NS) for the period ended June 30, 2006. NS is a large accelerated filer operating as a Class I railroad. The report covers the three and six months ended June 30, 2006, comparing results to the same periods in 2005.

Key Financial Metrics

Liquidity: Cash and short-term investments totaled $1.5 billion at June 30, 2006. Working capital was $567 million.

Material Changes vs. Prior Period

• Revenue Growth: Revenues increased 11% in Q2 and 14% year-to-date (YTD), driven by higher rates (including fuel surcharges) and traffic volume growth. Fuel surcharges accounted for approximately 60% of the revenue per unit increase.
• Expense Increases: Operating expenses rose 10% in Q2 and 11% YTD. Diesel fuel expenses surged 60% in Q2 and 57% YTD due to higher prices and the expiration of fuel hedging contracts. Compensation costs increased due to the adoption of SFAS 123(R) regarding stock-based compensation.
• Net Income Variance: Q2 2006 net income was $49 million lower than Q2 2005. This decrease is primarily attributed to the absence of a $96 million tax benefit from Ohio tax law changes and a $24 million benefit from coal rate case settlements recorded in 2005. Excluding these one-time 2005 items, operating performance improved.
• Operating Ratio: Improved to 71.7% in Q2 2006 from 72.5% in Q2 2005, despite rising fuel costs, due to strong revenue growth.

Guidance, Outlook, and Risks

• Outlook: Management expects volume growth to remain consistent with current levels for the remainder of 2006. Capital expenditures for the full year are expected to be approximately $1.2 billion, funded by internally generated cash.
• Tax Credits: High oil prices have triggered a phase-out of synthetic fuel tax credits. NS estimates a 62% phase-out for 2006, which reduced net benefits by $16 million compared to 2005. If production does not resume, the effective tax rate for the second half of the year is projected to be approximately 37%.
• Joint Venture: NS formed a joint venture (Meridian Speedway LLC) with Kansas City Southern, contributing $100 million initially with a total commitment of $300 million to improve rail capacity.
• Risks:
  • Fuel Prices: Continued volatility in diesel fuel prices impacts margins, though fuel surcharges cover ~90% of revenues.
  • Labor: Collective bargaining agreements are in mediation; a strike could occur if mediation fails and an Emergency Board is not appointed.
  • Environmental: Liabilities for environmental exposures were $57 million at June 30, 2006, across 180 known locations.
  • Accounting Changes: Adoption of SFAS 123(R) increased compensation expense by $28 million for the six months ended June 30, 2006.

Investor Verification Checklist

• One-Time Items: Verify the impact of the $120 million in 2005 non-recurring benefits (tax law changes and rate case settlements) when comparing year-over-year net income.
• Fuel Hedging: Confirm that the fuel hedging program has ended (last contracts settled in Q2 2006), leaving the company fully exposed to spot fuel price volatility.
• Tax Credit Phase-out: Monitor the final Reference Price for oil for 2006 to determine if the estimated 62% phase-out of synthetic fuel credits requires further adjustment in the second half of the year.
• Capital Allocation: Review the $186 million spent on share repurchases in the first six months and the $100 million initial investment in the Meridian Speedway joint venture.
• Compensation Accounting: Note the $28 million increase in stock-based compensation expense due to the new SFAS 123(R) standard, which affects operating margins.