NSC

Norfolk Southern Corp. 10-Q Summary: Period Ended September 30, 1999

Business Context and Reporting Period

This Form 10-Q covers the quarterly and nine-month periods ended September 30, 1999. The reporting period is defined by a major structural change: on June 1, 1999, Norfolk Southern Railway (NSR) commenced operations over a portion of Conrail's properties (the "Northern Region"). This integration increased NSR's route miles and workforce by approximately 50%. The financial results reflect five months of pre-integration operations and four months of post-integration operations, which were significantly impacted by system congestion and integration difficulties.

Key Financial Metrics

Liquidity and Debt: As of September 30, 1999, total assets were $19.1 billion. The company reported a working capital deficit of $738 million, compared to $204 million at year-end 1998. Total debt-to-total capitalization stood at 57.4%. Cash and cash equivalents were $41 million.

Material Changes vs. Prior Period

• Revenue Growth: Railway operating revenues increased 43% in Q3 and 17% for the nine months ended Sept 30, 1999, compared to 1998. This growth was driven primarily by the addition of Northern Region traffic volume.
• Profitability Decline: Despite revenue growth, Net Income plummeted 88% in Q3 and 64% for the nine-month period. Income from continuing operations dropped 87% in Q3 and 56% for the nine months.
• Expense Surge: Operating expenses rose 71% in Q3 and 31% for the nine months. This was due to the 50% increase in workforce, new "Conrail rents and services" costs ($141M in Q3), and integration-related costs (estimated at $116M in Q3 and $176M for the nine months).
• Operating Ratio Deterioration: The railway operating ratio worsened significantly to 90.3% in Q3 (from 75.4% in 1998) and 84.4% for the nine months (from 74.9%). Management estimates integration difficulties increased the ratio by 10.7 percentage points in Q3.
• Discontinued Operations: The 1998 results included a $105 million after-tax gain from the sale of the motor carrier subsidiary, which is absent in 1999.

Guidance, Outlook, and Risks

Management Commentary: Management attributes the decline in operating income to system congestion and traffic diversions caused by integration difficulties. These issues are estimated to have reduced operating income by $175 million in Q3 and $267 million since June 1. While progress is being made, additional labor and equipment resources are required to clear congestion. Fourth-quarter revenues for coal, general merchandise, and intermodal are expected to exceed 1998 levels, but the operating ratio is expected to remain adversely affected until service improves.

Year 2000 Compliance: NS is actively managing Year 2000 compliance. Critical mainframe applications have been remediated and implemented. Incremental costs incurred through Sept 30, 1999, are immaterial, with total expected costs around $25 million. Risks remain regarding third-party compliance.

Contingencies and Litigation:

• Conrail Integration Risk: A long-term failure to successfully integrate the Northern Region could have a substantial adverse impact on financial position and liquidity.
• Litigation: A $175 million punitive damage verdict was returned against a subsidiary (AGS) in a 1987 chemical explosion case. Management believes the ultimate liability is unlikely to have a material adverse effect, noting that other defendants are also liable and a settlement is being pursued.
• Coal Industry Regulation: A recent federal court decision regarding common mining practices could adversely affect coal traffic if sustained.

Investor Verification Checklist

• Integration Progress: Verify the timeline for resolving system congestion and the associated cost of service alteration and labor incentives.
• Working Capital: Confirm the company's ability to manage the $738 million working capital deficit, specifically the $400 million in notes due May 1, 2000, and reliance on commercial paper.
• Conrail Accounting: Review the treatment of "Conrail rents and services" and the equity method accounting for the Conrail investment, noting the $4.0 billion difference between investment value and underlying equity.
• Coal Market Exposure: Assess the impact of weak export coal demand and potential regulatory changes on the coal segment, which saw a 31% volume drop in exports for the nine-month period.
• Year 2000 Status: Monitor the completion of system integration testing for nonmainframe and enterprise systems scheduled for year-end.