FORM 10-Q
SECURITIES AND EXCHANGE COMMISSIONWASHINGTON, D.C. 20549
For the quarter ended September 24, 2004
OR
Commission File Number 1-8022
CSX CORPORATION
(904) 359-3200
No Change
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of September 24, 2004: 214,829,471 shares.
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CSX CORPORATION AND SUBSIDIARIES
Consolidated Income Statements (Unaudited)
See accompanying Notes to Consolidated Financial Statements (unaudited).
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CSX CORPORATION AND SUBSIDIARIESITEM 1: FINANCIAL STATEMENTS
Consolidated Balance Sheets
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Consolidated Cash Flow Statements (Unaudited)
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NOTE 1. BASIS OF PRESENTATION
In the opinion of management, the accompanying consolidated financial statements contain all adjustments necessary to fairly present the financial position of CSX Corporation and subsidiaries (“CSX” or the “Company”) at September 24, 2004 and December 26, 2003, the results of its operations for the quarter and nine months ended September 24, 2004, and September 26, 2003 and cash flows for the nine months ended September 24, 2004 and September 26, 2003, such adjustments being of a normal recurring nature. Certain prior-year data has been reclassified to conform to the 2004 presentation.
The Company suggests that these financial statements be read in conjunction with the financial statements and the notes included in the Company’s most recent Annual Report on Form 10-K, 2004 First and Second Quarterly Reports on Form 10-Q and any Current Reports on Form 8-K.
CSX follows a 52/53 week fiscal reporting calendar. Fiscal year 2004 consists of a 53-week year ending on December 31, 2004. Fiscal year 2003 consisted of 52 weeks ended on December 26, 2003. The financial statements presented are for the 13-week quarters ended September 24, 2004 and September 26, 2003, the 39-week periods ended September 24, 2004 and September 26, 2003, and as of December 26, 2003. In 2004, the fourth quarter ending December 31, 2004, consists of 14 weeks.
Other comprehensive income for the third quarter was $ 60 million resulting from the increase in fair value of fuel derivative instruments. (See Note 10, Derivative Financial Instruments) Other comprehensive income for the nine months ended September 24, 2004 was $155 million resulting from the increase in the fair value of fuel derivative instruments and a reduction in the Company’s additional minimum pension liability. Total comprehensive income approximated net earnings for the quarter and nine months ended September 26, 2003.
NOTE 2. EARNINGS PER SHARE
The following table sets forth the computation of basic earnings per share and earnings per share, assuming dilution:
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CSX CORPORATION AND SUBSIDIARIESITEM 1: FINANCIAL STATEMENTSNotes to Consolidated Financial Statements (Unaudited)
NOTE 2. EARNINGS PER SHARE, Continued
Earnings per share is based on the weighted-average number of common shares outstanding. Earnings per share, assuming dilution, is based on the weighted-average number of common shares outstanding adjusted for the effect of potentially dilutive common shares, mainly arising from employee stock options. Potentially dilutive common shares of CSX include stock options and awards, and common stock that would be issued relating to convertible long-term debt. During the quarter and nine months ended September 24, 2004, 67 thousand and 259 thousand options, respectively, were exercised. During the quarter and nine months ended September 26, 2003, 36 thousand and 211 thousand options, respectively, were exercised.
Certain potentially dilutive common shares at September 24, 2004 and September 26, 2003 were excluded from the computation of earnings per share, assuming dilution, since their exercise prices were greater than the average market price of the common shares during the period or contingent conditions for conversion were not met. The following table indicates information about potentially dilutive common shares excluded from the computation of earnings per share:
Potentially dilutive common shares include approximately 10 million shares associated with convertible debentures issued by the Company in 2001, which mature October 30, 2021.
At its September 29-30, 2004 meeting, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings Per Share. The EITF states that contingently convertible debt instruments are subject to the if-converted method under Financial Accounting Standards Board’s (“FASB”) Statement of Financial Standards (“SFAS”) 128, Earnings Per Share, regardless of fulfillment of any of the contingent features included in the instrument. The EITF concluded that this consensus would have the same transition date as the anticipated amendment to SFAS 128 expected to be issued by the FASB during the fourth quarter. The amendment is expected to be effective for periods ending after December 15, 2004 and the consensus must be applied by restating all periods during which the instrument was outstanding.
Beginning in the fourth quarter of 2004, CSX may be required to include approximately 10 million shares underlying its convertible debt instrument using the if-converted method in the computation of earnings per share, assuming dilution. The dilutive impact for all periods is expected to be in the range of 2%-5%.
As a result of the anticipated amendment to SFAS 128, during the third quarter, CSX amended the terms of these debentures to surrender its right to pay the purchase price, in whole or in part, in shares of CSX’s common stock for debentures tendered to CSX at the option of holders on certain specified purchase dates. As a result, CSX will be required to pay the purchase price for such debentures on such specified purchase dates in cash.
Holders may in addition convert their debentures into shares of the Company’s common stock at a conversion rate of 17.75 common shares per debenture, subject to customary anti-dilution adjustments, if any of the following conditions are satisfied:
The accreted conversion price of the debentures at September 24, 2004 was $47.53 and the threshold price to be met in order to convert the debentures into common stock was $56.56 per common share. At September 24, 2004 and December 26, 2003, outstanding debentures are included in long-term debt, at a carrying value of $462 million and $447 million, respectively.
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These potentially dilutive common shares have been excluded from the computation of earnings per share, assuming dilution, because none of the conditions for conversion of the debentures have been met. A substantial increase in the fair market value of the Company’s stock price could trigger contingent conditions for conversion and allow holders to convert their debentures into CSX common stock and thus negatively impact basic earnings per share.
NOTE 3. DEBT AND CREDIT AGREEMENTS
In February 2004, the Company executed a $100 million credit agreement that matures February 25, 2005. Borrowings under the facility bear interest at a rate that varies with LIBOR plus an applicable spread. As of September 24, 2004, the Company had $100 million in aggregate principal amount outstanding under this agreement.
In June 2004, the Company executed a $300 million credit agreement with a maturity date of December 29, 2004. Borrowings under the facility bore interest at a rate that varies with LIBOR plus an applicable spread. As of September 24, 2004, the Company had repaid the entire aggregate principal amount outstanding under this agreement and terminated this agreement.
In August 2004, the Company issued a $300 million of floating rate notes with a maturity date of August 3, 2006. The notes bear interest at a rate that varies with LIBOR plus an applicable spread. These notes are not redeemable prior to maturity.
Outstanding debt obligations of $300 million matured in August, 2004. The Company settled these obligations with cash and short-term investments on hand.
The weighted average interest rate on outstanding short-term borrowings of $103 million was 1.76% as of September 24, 2004. The Company had $2 million of short-term borrowings outstanding as of December 26, 2003.
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NOTE 3. DEBT AND CREDIT AGREEMENTS, Continued
The Company has a $1.2 billion five-year unsecured revolving credit facility expiring in May 2009 and a $400 million 364-day unsecured revolving credit facility expiring in May 2005. The facilities were entered into in May 2004 on terms substantially similar to the facilities they replaced: a $345 million unsecured revolving credit facility that expired in May 2004 and a $1.0 billion unsecured revolving credit facility that would have expired in May 2006. Generally, these facilities may be used for general corporate purposes, to support the Company’s commercial paper, and for working capital. Neither of the credit facilities were drawn on as of September 24, 2004. Commitment fees and interest rates payable under the facilities are similar to fees and rates available to comparably rated investment-grade borrowers. Similar to the credit facilities they replaced, these credit facilities allow for borrowings at floating (LIBOR-based) rates, plus a spread, depending upon our senior unsecured debt ratings. At September 24, 2004, the Company was in compliance with all covenant requirements under the facilities.
NOTE 4. DIVESTITURES
In February 2003, CSX conveyed most of its interest in its domestic container-shipping subsidiary, CSX Lines LLC (“CSX Lines”), to a new venture formed with The Carlyle Group for approximately $300 million (gross cash proceeds of approximately $240 million, $214 million net of transaction costs, and $60 million of securities). CSX Lines was subsequently renamed Horizon Lines LLC (“Horizon”). Horizon subleased vessels and equipment from certain affiliates of CSX covering the primary financial obligations related to $265 million of leases under which CSX or one of its affiliates will remain a lessee / sublessor or guarantor. A deferred pretax gain of approximately $127 million as a result of the transaction is being recognized over the 12-year sub-lease term. The securities have a term of 7 years and a preferred return feature. During the third quarter of 2003, CSX received a $15 million payment from Horizon Lines, which included $3 million of interest, in return of a portion of its investment in Horizon. $226 million is shown as proceeds from divestiture in the investing section of the Consolidated Statement of Cash Flows and $3 million is included in net earnings.
In July 2004, Horizon was acquired by an unrelated third party, and CSX received $59 million, which included $48 million for the purchase of its ownership interest in Horizon, $4 million of interest, and a performance payment of $7 million, which will also be recognized over the 12-year sub-lease term. $55 million is shown as proceeds from divestiture in the investing section of the Consolidated Statement of Cash Flows and $4 million is included in net earnings. However, CSX and one of its affiliates will continue to remain a lessee / sublessor or guarantor on certain vessels and equipment as long as the subleases remain in effect. (See Note 13, Commitments and Contingencies.)
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SFAS 143, “Accounting for Asset Retirement Obligations” was issued in 2001. This statement addresses financial accounting and reporting for legal obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. In conjunction with the group-life method of accounting for asset costs, the Company historically accrued crosstie removal costs as a component of depreciation, which is not permitted under SFAS 143. With the adoption of SFAS 143 in fiscal year 2003, CSX recorded pretax income of $93 million, $57 million after tax, or 26 cents per share, as a cumulative effect of an accounting change in the first quarter, representing the reversal of the accrued liability for crosstie removal costs. The adoption of SFAS 143 did not have a material effect on prior reporting periods, and it will not have a material effect on future earnings.
SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure” was issued in December 2002. SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to SFAS 123’s fair value method of accounting for stock-based employee compensation and require disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation. Effective beginning with fiscal year 2003, CSX voluntarily adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation,” and adopted the disclosure requirements of SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of SFAS 123.” In accordance with the prospective method of adoption permitted under SFAS 148, stock-based awards issued subsequent to fiscal year 2002 are accounted for under the fair value recognition provisions of SFAS 123 utilizing the Black-Scholes valuation method and, accordingly, are expensed. (See Note 11, Stock Based Compensation)
In 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” which requires a variable interest entity (“VIE”) to be consolidated by a company that is subject to a majority of the risk of loss from the VIE’s activities or is entitled to receive a majority of the entity’s residual returns, or both. Under that guidance, CSX consolidated Four Rivers Transportation, Inc. (“FRT”), a shortline railroad, into its financial statements at the beginning of fiscal 2004. Previously, FRT was accounted for under the equity method of accounting. Other income includes net equity earnings for FRT for the quarter and nine months ended September 26, 2003. The following table indicates the impact of consolidating FRT in 2004 compared to equity method accounting in 2003.
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NOTE 6. INVESTMENT IN AND INTEGRATED RAIL OPERATIONS WITH CONRAIL
As previously reported, in June 2003 CSX, Norfolk Southern Corporation (“NS”), and Conrail Inc. (“Conrail”) jointly filed a petition with the Surface Transportation Board (“STB”) to establish direct ownership and control by CSX’s and NS’ respective subsidiaries, CSX Transportation, Inc. (“CSXT”) and Norfolk Southern Railway Company (“NSR”), of CSX’s and NS’ portions of the Conrail system already operated by them separately and independently under various agreements. These portions of the Conrail system were owned by Conrail’s subsidiaries, New York Central Lines, LLC (“NYC”) and Pennsylvania Lines, LLC (“PRR”). In August 2004, the following events occurred: (i) the ownership of NYC and PRR was transferred to CSXT and NSR, respectively, and (ii) CSXT consummated an exchange offer of new unsecured securities of subsidiaries of CSXT and NSR for unsecured securities of Conrail. The exchange offer was the final stage in the restructuring of Conrail’s unsecured indebtedness as described in the parties joint petition filed with the STB.
CSXT and NSR offered unsecured debt securities of newly formed subsidiaries in an approximate 42%/58% ratio in exchange for Conrail’s unsecured debentures. The debt securities issued by each respective subsidiary were fully and unconditionally guaranteed by CSXT and NSR. Upon completion of the transaction, the subsidiaries merged into CSXT and NSR, respectively, and the new debt securities thus became direct unsecured obligations of CSXT and NSR. Conrail’s secured debt and lease obligations remained obligations of CSXT or NSR. Conrail’s secured debt and lease obligations of Conrail are supported by new leases and subleases which became the direct lease and sublease obligations, also in an approximate 42%/58% ratio, of CSXT and NSR.
Prior to the transaction, CSX’s and NS’ indirect ownership interest in NYC and PRR mirror their ownership interest in Conrail (42% for CSX and 58% for NS). Subsequent to the transaction, CSX obtained direct ownership of all NYC and NS obtained direct ownership PRR. Thus, CSX in effect received NS’s 58% indirect ownership in NYC and NS in effect received CSX’s 42% indirect ownership of PRR. The receipt of the interests not already indirectly owned by CSX was accounted for at fair value. The receipt of the NYC interest already indirectly owned by CSX was accounted for using CSX’s basis in amounts already included within CSX’s investment in Conrail.
As a result of the transaction, the Company recognized a net gain of $16 million, after tax, which is included in other income. The accounting for the transaction could be adjusted upon receipt of the final third party valuation and allocation of fair value to individual assets.
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NOTE 6. INVESTMENT IN AND INTEGRATED RAIL OPERATIONS WITH CONRAIL, Continued
The Company recorded this transaction at fair value based on the preliminary results of an independent valuation. The following tables summarize the estimated fair value of the acquired assets and liabilities assumed at the date of the spin-off and at the end of the prior year and its effects on the Company’s Consolidated Balance Sheets as of September 24, 2004 and December 26, 2003. Fair value adjustments are non-cash transactions and, accordingly, have no cash impact on the Consolidated Cash Flow Statements:
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The following table illustrates the pro forma effect on the Consolidated Income Statements as if the spin-off transaction had been completed as of the beginning of the periods.
Beginning September the impact of the transaction included in the Company’s Consolidated Income Statement.
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As a result of the spin-off transaction, CSX’s investment in Conrail no longer includes the amounts related to NYC and PRR. Instead the assets and liabilities of NYC are reflected in their respective line items in CSX’s Consolidated Balance Sheet. As noted, Conrail will continue to own, manage, and operate the Shared Assets Areas. However, this transaction effectively decreased rents paid to Conrail after the transaction date, as assets previously leased from Conrail are now owned by CSX. Due to the spin-off transaction the future minimum payments to Conrail under the operating, equipment and shared area agreements will be significantly reduced.
Accounting and Financial Reporting Effects
CSX’s rail and intermodal operating revenue includes revenue from traffic moving on Conrail property. Operating expenses include costs incurred to handle such traffic and operate the Conrail lines. Rail operating expense includes an expense category, “Conrail Rents, Fees and Services,” which reflects:
Detail of Conrail Rents, Fees and Services
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Conrail Financial Information
Summary financial information for Conrail for its fiscal periods ended September 30, 2004 and 2003 and at December 31, 2003 is as follows:
The decrease in Conrail’s total assets and Stockholder’s equity were the result of the Spin-off transaction.
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Transactions with Conrail
As listed below, CSX has amounts payable to Conrail representing expenses incurred under the operating, equipment and shared area agreements with Conrail.
The agreement under which CSX operated its allocated portion of the Conrail route system was terminated upon consummation of the spin-off transaction, as CSX then became the direct owner of its allocated portion of the Conrail system. Agreements for subleasing Conrail equipment operated by CSX cover varying terms. CSX is responsible for all costs of operating, maintaining, and improving the equipment under these agreements.
NOTE 7. ACCOUNTS RECEIVABLE
Sale of Accounts Receivable
As of June 2003, CSXT discontinued its accounts receivable securitization program. Prior to that, CSXT sold, without recourse, a revolving pool of accounts receivable to CSX Trade Receivables Corporation (“CTRC”), a bankruptcy-remote entity wholly owned by CSX. CTRC transferred the accounts receivable to a master trust and caused the trust to issue multiple series of certificates representing undivided interests in the receivables. The certificates issued by the master trust were sold to investors, and the proceeds from those sales were paid to CSXT. Net losses associated with the sale of receivables were $10 million for the nine months ended September 26, 2003.
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NOTE 7. ACCOUNTS RECEIVABLE, Continued
Allowance for Doubtful Accounts
The Company maintains an allowance for doubtful accounts based on the expected collectibility of all accounts receivable. The allowance for doubtful accounts is included in the balance sheet as follows:
NOTE 8. OPERATING EXPENSE
Operating expense consists of the following:
Operating expenses include amounts from the Company’s domestic container-shipping subsidiary, CSX Lines, through February of 2003, when most of CSX’s interest in the entity was conveyed to a new venture. (See Note 4, Divestitures)
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NOTE 9. OTHER INCOME
Other income consists of the following:
NOTE 10. DERIVATIVE FINANCIAL INSTRUMENTS
CSX uses derivative financial instruments to manage its overall exposure to fluctuations in interest rates and fuel costs.
Interest Rate Swaps
CSX has entered into various interest rate swap agreements on the following fixed rate notes:
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NOTE 10. DERIVATIVE FINANCIAL INSTRUMENTS, Continued
Under these agreements, the Company will pay variable interest based on LIBOR in exchange for a fixed rate, effectively transforming the notes to floating rate obligations. The interest rate swap agreements are designated and qualify as fair value hedges and the gain or loss on the derivative instrument, as well as the offsetting gain or loss on the fixed rate note attributable to the hedged risk, are recognized in current earnings during the period of change in fair values. Hedge effectiveness is measured at least quarterly based on the relative change in fair value of the derivative contract in comparison with changes over time in the fair value of the fixed rate notes. Any change in fair value resulting from ineffectiveness, as defined by SFAS 133, “Accounting For Derivative Instruments and Hedging Activities,” is recognized immediately in earnings. The Company’s interest rate swaps qualify as perfectly effective fair value hedges, as defined by SFAS 133. As such, there was no ineffective portion to the hedge recognized in earnings during the current or prior year periods. Long-term debt has been increased by $39 million and $55 million for the fair market value of the interest rate swap agreements at September 24, 2004 and December 26, 2003, respectively.
The differential to be paid or received under these agreements is accrued based on the terms of the agreements and is recognized in interest expense over the term of the related debt. The related amounts payable to, or receivable from, counterparties are included in other current liabilities or assets. Cash flows related to interest rate swap agreements are classified as “Operating Activities” in the Consolidated Cash Flow Statements. For the quarter and nine month periods ended September 24, 2004, the Company reduced interest expense by approximately $5 million and $26 million, respectively, as a result of the interest rate swap agreements that were in place during each period. For the quarter and nine month periods ended September 26, 2003, the Company reduced interest expense by approximately $11 million and $33 million, respectively. Fair value adjustments are non-cash transactions and, accordingly, have no cash impact on the Consolidated Cash Flow Statements.
The counterparties to the interest rate swap agreements expose the Company to credit loss in the event of non-performance. The Company does not anticipate non-performance by the counterparties.
Fuel Hedging
In the third quarter of 2003, CSX began a program to hedge a portion of its future locomotive fuel purchases. This program was established to manage exposure to fuel price fluctuations. In order to minimize this risk, CSX has entered into a series of swaps in order to fix the price of a portion of its estimated future fuel purchases.
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Following is a summary of outstanding fuel swaps:
The program limits fuel hedges to a 24-month duration and a maximum of 80% of CSX’s average monthly fuel purchased for any month within the 24-month period, and places the hedges among selected counterparties. Fuel hedging activity favorably impacted fuel expense for the quarter and nine months ended September 24, 2004 by $13 million and $17 million, respectively. Ineffectiveness, or the extent to which changes in the fair values of the fuel swaps did not offset changes in the fair values of the expected fuel purchases, was immaterial.
These instruments qualify, and are designated by management, as cash-flow hedges of variability in expected future cash flows attributable to fluctuations in fuel prices. The fair values of fuel derivative instruments are determined based upon current fair market values as quoted by third party dealers and are recorded on the balance sheet with offsetting adjustments to Accumulated Other Comprehensive Loss, a component of Shareholders’ Equity. Accumulated Other Comprehensive Loss included a gain, net of tax of approximately $107 million and $6 million as of September 24, 2004 and December 26, 2003, respectively, related to fuel derivative instruments. Fair value adjustments are non-cash transactions and, accordingly, have no cash impact on the Consolidated Cash Flow Statements.
The Company has temporarily suspended entering into new swaps in its fuel hedge program since the middle of the third quarter 2004. The Company will continue to monitor and assess the current issues facing the global fuel market place to decide when to resume trading under the program.
The counterparties to the fuel hedge agreements expose the Company to credit loss in the event of non-performance. The Company does not anticipate non-performance by the counterparties.
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NOTE 11. STOCK-BASED COMPENSATION
Effective beginning with fiscal year 2003, CSX has voluntarily adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation,” and adopted the disclosure requirements of SFAS 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of SFAS 123.” In accordance with the prospective method of adoption permitted under SFAS 148, the Company has adopted the fair value recognition provisions on a prospective basis and accordingly, expense of $1 million and $11 million was recognized in the quarter and nine months ended September 24, 2004, respectively, for stock options granted in May 2003. Stock compensation expense includes $6 million recorded in conjunction with the Company’s management restructuring for the nine month period ended September 24, 2004 (see Note 17, Management Restructuring), related to recognition of unamortized expense for 2003 stock option awards retained by terminated employees. In the quarter and nine months ended September 26, 2003 stock compensation expense of $2 million and $3 million, respectively, was recognized for stock options granted in May 2003.
The following table illustrates the pro forma effect on net earnings and earnings per share as if the fair value based method had been applied to all outstanding and unvested awards in each period:
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NOTE 12. CASUALTY, ENVIRONMENTAL AND OTHER RESERVES
Casualty, environmental and other reserves are provided for in the balance sheet as follows:
Casualty Reserves
Casualty reserves represent accruals for the uninsured portion of occupational injury and personal injury claims. The Company’s estimate of casualty reserves includes an estimate of incurred but not reported claims for asbestos and other occupational injuries to be received over the next seven years. Other occupational claims include allegations of exposure to certain materials in the workplace, such as solvents and diesel fuel, or alleged physical injuries, such as carpal tunnel syndrome or hearing loss.
In the third quarter of 2003, the Company changed its estimate of casualty reserves to include an estimate of incurred but not reported claims for asbestos and other occupational injuries. In conjunction with the change in estimate, the Company recorded a charge of $232 million in the third quarter of 2003 to increase its provision for these claims.
Asbestos and Other Occupational Injuries
The Company is assisted by third party professionals to project the number of asbestos and other occupational injury claims to be received over the next seven years and the related costs. Based on this analysis the Company established reserves for the probable and reasonably estimable asbestos and other occupational injury liabilities.
The methodology used by the third party to project future occupational injury claims was based largely on CSX’s recent experience, including claim-filing and settlement rates, injury and disease mix, open claims and claim settlement costs. However, projecting future occupational injury claims and settlements costs is subject to numerous variables that are difficult to predict. In addition to the significant uncertainties surrounding the number of claims that might be received, other variables, including the type and severity of the injury or disease alleged by each claimant, the long latency period associated with exposure, dismissal rates, costs of medical treatment, uncertainties surrounding the litigation process from jurisdiction to jurisdiction and from case to case and the impact of changes in legislative or judicial standards, may cause actual results to differ significantly from current estimates. Furthermore, predictions with respect to these variables are subject to greater uncertainty as the projection period lengthens. In light of these uncertainties, CSX believes that seven years is the most reasonable period for estimating future claims, and that claims received after that period are not reasonably estimable. CSX’s reserve for asbestos and other occupational claims on an undiscounted basis amounted to $332 million at September 24, 2004, compared to $357 million at December 26, 2003.
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NOTE 12. CASUALTY, ENVIRONMENTAL AND OTHER RESERVES, Continued
CSX increased its reserve for asbestos and other occupational claims by a net $206 million during the third quarter of 2003 to cover the estimate of incurred but not reported claims. Reflecting the additional provisions, CSX’s reserve for asbestos and other occupational claims on an undiscounted basis amounted to $350 million at September 26, 2003.
A summary of existing claims activity is as follows:
Approximately 5,600 of the open claims at September 24, 2004 are asbestos claims against the Company’s previously owned international container-shipping business, Sea-Land. Because the Sea-Land claims are claims against multiple vessel owners, the Company’s reserves reflect its portion of those claims. The remaining open claims have been asserted against CSXT. The Company had approximately $13 million reserved for the Sea-Land claims at September 24, 2004 and December 26, 2003.
Personal Injury
During the third quarter of 2003, CSX retained an independent actuarial firm to assess the value of CSX’s personal injury portfolio. Reserves for personal injury claims are $359 million and $355 million at September 24, 2004 and December 26, 2003, respectively.
CSX continues to retain an independent actuarial firm to assess the value of CSX’s personal injury portfolio. The methodology used by the actuary includes a development factor to reflect growth in the value of the Company’s personal injury claims. This methodology is based largely on CSX’s historical claims and settlement activity. Actual results may vary from estimates due to the type and severity of the injury, costs of medical treatments, and uncertainties surrounding the litigation process.
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Separation Liability
Separation liabilities at September 24, 2004, and December 26, 2003, include productivity charges recorded in 1991 and 1992 to provide for the estimated costs of implementing workforce reductions, improvements in productivity and other cost reductions at the Company’s major transportation units. The remaining separation liabilities are expected to be paid out over the next 15 to 20 years. Separation liabilities also include amounts payable under the Company’s management restructuring programs. (See Note 17, Management Restructuring)
Environmental Reserves
CSXT is a party to various proceedings, including administrative and judicial proceedings, involving private parties and regulatory agencies related to environmental issues. CSXT has been identified as a potentially responsible party (“PRP”) at approximately 253 environmentally impaired sites, many of which are, or may be, subject to remedial action under the Federal Superfund statute (“Superfund”) or similar state statutes. A number of these proceedings are based on allegations that CSXT, or its railroad predecessors, sent hazardous substances to the facilities in question for disposal. Some of the proceedings involve property formerly or currently owned by CSXT or its railroad predecessors. Proceedings arising under Superfund or similar state statutes can involve numerous other companies who generated the waste or owned or operated the property and involve the allocation of liability for costs associated with site investigation and cleanup, which could be substantial.
At least once each quarter, CSXT reviews its role with respect to each such location, giving consideration to a number of factors, including the type of cleanup required, the nature of CSXT’s alleged connection to the location (e.g., generator of waste sent to the site, or owner or operator of the site), the extent of CSXT’s alleged connection (e.g., volume of waste sent to the location and other relevant factors), the accuracy and strength of evidence connecting CSXT to the location, and the number, connection, and financial viability of other named and unnamed PRP’s at the location.
Based on the review process, CSXT has recorded reserves to cover estimated contingent future environmental costs with respect to such sites. The recorded liabilities for estimated future environmental costs at September 24, 2004, and December 26, 2003 were $59 million and $45 million, respectively. Approximately $6 million of the increase is attributable to liabilities assumed due to the Conrail spin-off transaction. These liabilities, which are undiscounted, include amounts representing CSXT’s estimate of unasserted claims, which CSXT believes to be immaterial. The liability includes future costs for all sites where the Company’s obligation is (1) deemed probable and (2) reasonably estimable. The liability includes future costs for remediation and restoration of sites as well as any significant ongoing monitoring costs, but excludes any anticipated insurance recoveries. The majority of the September 24, 2004 environmental liability is expected to be paid over the next seven years.
The Company does not currently possess sufficient information to reasonably estimate the amounts of additional liabilities, if any, on some sites until completion of future environmental studies. In addition, latent conditions at any given location could result in exposure, the amount and materiality of which cannot presently be reasonably estimated. Based upon information currently available, however, the Company believes its environmental reserves are adequate to take remedial actions to comply with present laws and regulations, and that the ultimate liability for these matters, if any, will not materially affect its overall results of operations and financial condition.
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NOTE 13. COMMITMENTS AND CONTINGENCIES
Purchase Commitments
The Company has a commitment under a long-term maintenance program for approximately 40% of CSXT’s fleet of locomotives. The agreement expires in 2026 and approximates $2.6 billion. The long-term maintenance program is intended to provide CSX access to efficient, high-quality locomotive maintenance services at fixed price levels through the term of the program. Under the program, CSX paid $39 million and $114 million during the quarter and nine month periods ended September 24, 2004, respectively. During the quarter and nine months periods ended September 26, 2003, the Company paid $32 million and $98 million, respectively.
Self-Insurance
The Company uses a combination of third-party and self-insurance, obtaining substantial amounts of commercial insurance for potential losses for third-party liability and property damages. Specified levels of risk (up to $35 million for property and $25 million for liability per occurrence) are retained on a self-insurance basis.
Guarantees
The Company and its subsidiaries are contingently liable individually and jointly with others as guarantors of obligations principally relating to leased equipment, joint ventures and joint facilities used by the Company in its business operations. Utilizing the Company’s guarantee for these obligations allows the obligor to take advantage of lower interest rates and obtain other favorable terms. Guarantees are contingent commitments issued by the Company that could require CSX or one of its affiliates to make payment or to perform certain actions to the guaranteed party based on another entity’s failure to perform. As of September 24, 2004, the Company’s guarantees can be segregated into three main categories:
The maximum amount of future payments the Company could be required to make under these guarantees is the amount of the guarantees themselves.
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NOTE 13. COMMITMENTS AND CONTINGENCIES, Continued
STB Proceeding
In 2001, Duke Energy Corporation (“Duke”) filed a complaint before the STB alleging that certain CSXT common carrier coal rates are unreasonably high. In February 2004, the STB issued a decision finding that the CSXT common carrier rates are reasonable. While approving the rate levels, the STB also invited Duke to request a phase-in of rate increases over some time period. The nature and amount of any such phase-in is uncertain, and would only apply to billings subsequent to December 2001. In October 2004, the STB issued a decision denying Duke’s petition for reconsideration of its February 2004 ruling. CSXT will continue to consider and pursue all available legal defenses in this matter. Administrative and legal appeals are possible, and could take several years to resolve. An unfavorable outcome with respect to the phase-in would not have a material effect on the Company’s financial position.
Contract Settlement
In 2002, the Company received $44 million as the first of two payments to settle a contract dispute. During 2002, the Company recognized approximately $7 million of the first payment in other income as this amount related to prior periods. The remaining $37 million will be recognized over the contract period, which ends in 2020. The second payment of $23 million was received in 2003 and will be recognized over the contract period which ends in 2020. The results of this settlement will provide an average of approximately $3 million in annual pretax earnings through 2020.
Matters Arising Out of Sale of International Container-Shipping Assets
In 2003, CSX finalized a settlement agreement with Maersk resolving all remaining material disputes pending directly between the two companies, consisting predominantly of two major disputes. The first dispute involved a post-closing working capital adjustment to the sale price for which the Company had recorded a receivable of approximately $70 million. The second dispute involved a claim of 425 million Dutch Guilders (approximately $180 million at then prevailing currency exchange rates) plus interest by European Container Terminals (“ECT”) alleging breaches of contract by the Company at the Rotterdam container terminal facility owned by ECT.
Also in 2003, CSX entered into a final settlement agreement with Maersk allocating responsibility between the two companies for third party claims and litigation relating to the assets acquired by Maersk.
The two settlements reduced the Company’s 2003 earnings by $108 million pretax, $67 million after tax. This charge is reflected in the financial statements as an additional loss on the sale of the international container-shipping assets. Neither settlement has a material impact on cash flows.
Other Legal Proceedings
CSX is involved in routine litigation incidental to its business and is a party to a number of legal actions and claims, various governmental proceedings and private civil lawsuits, including those related to environmental matters, Federal Employers’ Liability Act claims by employees, other personal injury claims, and disputes and complaints involving certain transportation rates and charges. Some of the legal proceedings include claims for
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punitive as well as compensatory damages, and others purport to be class actions. While the final outcome of these matters cannot be predicted with certainty, considering among other things the meritorious legal defenses available and liabilities that have been recorded along with applicable insurance, it is the opinion of CSX management that none of these items will have a material adverse effect on the results of operations, financial position or liquidity of CSX. However, an unexpected adverse resolution of one or more of these items could have a material adverse effect on the results of operations in a particular quarter or fiscal year. The Company is also party to a number of actions, the resolution of which could result in gain realization in amounts that could be material to results of operations in the quarters received.
NOTE 14. BUSINESS SEGMENTS
The Company operates in three business segments: rail, intermodal, and international terminals. The rail segment provides rail freight transportation over a network of more than 23,000 route miles in 23 states, the District of Columbia and two Canadian provinces. The intermodal segment provides integrated rail and truck transportation services and operates a network of dedicated intermodal facilities across North America. The international terminals segment operates container freight terminal facilities and related businesses in Asia, Europe, Australia, Latin America and the United States. The Company’s segments are strategic business units that offer different services and are managed separately. The rail and intermodal segments are viewed on a combined basis as Surface Transportation operations.
The Company evaluates performance and allocates resources based on several factors, of which the primary financial measure is business segment operating income. The accounting policies of the segments are the same as those described in the summary of significant accounting policies (Note 1, Basis of Presentation) in the CSX 2003 Annual Report on Form 10-K, except that for segment reporting purposes, CSX includes minority interest expense on the international terminals segment’s joint venture businesses in operating expense. These amounts are reclassified through eliminations in CSX’s consolidated financial statements to other income. Intersegment sales and transfers are generally accounted for as if the sales or transfers were to third parties, at current market prices.
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NOTE 14. BUSINESS SEGMENTS, Continued
Business segment information for the quarters and nine months ended September 24, 2004 and September 26, 2003 is as follows:
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A reconciliation of the totals reported for the business segments to the applicable line items in the consolidated financial statements is as follows:
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NOTE 15. SUMMARIZED CONSOLIDATING FINANCIAL DATA
During 1987, Sea-Land, a former consolidated subsidiary of the Company, entered into agreements to sell and lease back, by charter, three new U.S.built, U.S.-flag, D-7 class container ships. The ships were not included in the sale of international liner assets to Maersk in December 1999 and the related debt remains an obligation of CSX Lines. CSX has guaranteed the obligations of CSX Lines pursuant to the related charters, which, along with the container ships, serve as collateral for debt securities registered with the SEC. As noted in Note 3, Divestitures, of the CSX 2003 Annual Report on Form 10-K, CSX agreed to convey certain assets of CSX Lines to Horizon. These obligations are not part of this transaction and another CSX entity, CSX Vessel Leasing, became the obligor in 2003. In accordance with SEC disclosure requirements, consolidating summarized financial information for the parent and obligor are as follows (certain prior year amounts have been reclassified to conform to the 2004 presentation):
Consolidating Income Statement
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NOTE 15. SUMMARIZED CONSOLIDATING FINANCIAL DATA, Continued
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Consolidating Balance Sheet
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Consolidating Cash Flow Statements
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NOTE 16. EMPLOYEE BENEFIT PLANS
The Company sponsors defined benefit pension plans, principally for salaried personnel. The plans provide eligible employees with retirement benefits based primarily on years of service and compensation rates near retirement. A substantial portion of benefits provided under the management restructuring initiatives (see Note 17, Management Restructuring) will be paid from the Company’s defined benefit pension plans and postretirement medical plan.
In addition to the defined benefit pension plans, the Company sponsors three plans that provide medical and life insurance benefits to most full-time salaried employees upon their retirement. The postretirement medical plans are contributory (partially funded by participating retirees), with retiree contributions adjusted annually. The life insurance plan is non-contributory.
The following table presents components of net periodic benefit cost for the quarters and nine months ended September 24, 2004 and September 26, 2003:
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NOTE 16. EMPLOYEE BENEFIT PLANS, Continued
The Company previously disclosed in its 2003 Annual Report on Form 10-K, that it expected to contribute $14 million to its pension plan in 2004. As of September 24, 2004, the Company has contributed $11 million to its pension plan. The Company does not presently anticipate additional contributions to its pension plan during 2004.
Due to the termination of employees under the management restructuring plan (See Note 17, Management Restructuring), a curtailment occurred in the Company’s defined benefit pension plan and postretirement medical plan. The estimated cost of the curtailments of $24 million was included in the management restructuring charge for the nine months ended 2004. Due to the curtailments, the Company was required to update its measurement of the assets and obligations of these plans, which affected the net periodic benefit costs beginning in the second quarter of 2004.
In connection with recognition of the curtailments, the Company is required to estimate and record the effects of the Medicare Prescription Drug, Improvement and Modernization Act of 2003 (“Act”). The Company believes that a portion of its medical plan’s prescription drug benefit will qualify as actuarially equivalent to Medicare Part D based upon a review by the plan’s health and welfare actuary of the plan’s prescription drug benefit compared with the prescription drug benefit that would be paid under Medicare Part D beginning in 2006. The reduction in the postretirement benefit obligation as a result of the Act was approximately $25 million. There was no immediate impact on net earnings as an unrecognized gain will be recorded. The effects of the Act are reflected in net postretirement benefit costs as the unrecognized gain is amortized, which began in the second quarter of 2004. The Company expects 2004 postretirement benefit costs will be reduced by approximately $3 million due to the Act.
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NOTE 17. MANAGEMENT RESTRUCTURING
The Company recorded separation expenses for the following:
In total the Company recorded management restructuring expenses of $3 million and $77 million for the quarter and nine months ended September 24, 2004, for separation expense, pension and post-retirement benefit curtailment charges, stock compensation expense and other related expenses.
The total cost of the program through the third quarter of 2004 is $111 million. The majority of separation benefits will be paid from CSX’s qualified pension plan, with the remainder being paid from general corporate funds. See the table below for a rollforward of significant components of the restructuring charge.
(a) Includes payments from the qualified pension plan and general corporate funds.
(b) Related to recognition of unamortized expense for 2003 stock option awards retained by terminated employees.
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OVERVIEW
General
CSX operates one of the largest rail networks in the United States and also arranges for and provides integrated rail and truck (“intermodal”) transportation services across the United States and key markets in Canada and Mexico. Its marine operations include an international terminal services company, which operates and develops container terminals, distribution facilities and related terminal activities. CSX also owns and operates the Greenbrier, a AAA Five-Diamond resort located in White Sulphur Springs, West Virginia.
In February 2003, CSX conveyed most of its interest in its domestic container-shipping subsidiary, CSX Lines, to a new venture formed with The Carlyle Group for approximately $300 million (gross cash proceeds of approximately $240 million, $214 million net of transaction costs, and $60 million of securities). CSX Lines was subsequently renamed Horizon. Horizon subleased vessels and equipment from certain affiliates of CSX covering the primary financial obligations related to $300 million of leases under which CSX or one of its affiliates will remain a lessee / sublessor or guarantor. A deferred pretax gain of approximately $127 million as a result of the transaction is being recognized over the 12-year sub-lease term. The securities have a term of 7 years and a preferred return feature. During the third quarter of 2003, CSX received a $15 million payment from Horizon Lines, which included $3 million of interest, in return of a portion of its investment in Horizon. $226 million is shown as proceeds from divestiture in the investing section of the Consolidated Statement of Cash Flows and $3 million is included in net earnings. (See Note 4, Divestitures)
In July 2004, Horizon was acquired by an unrelated third party, and CSX received $59 million, which included $48 million for the purchase of its ownership interest in Horizon, $4 million of interest, and a performance payment of $7 million, which will also be recognized over the 12-year sub-lease term. $55 million is shown as proceeds from divestiture in the investing section of the Consolidated Statement of Cash Flows and $4 million is included in net earnings. However, CSX and one of its affiliates will continue to remain a lessee / sublessor or guarantor on certain vessels and equipment as long as the subleases remain in effect. (See Note 13, Commitments and Contingencies)
CSX Transportation Inc.
CSXT is the largest rail network in the eastern United States, providing rail freight transportation over a network of more than 23,000 route miles in 23 states, the District of Columbia and two Canadian provinces. Headquartered in Jacksonville, Florida, CSXT accounted for 82% of CSX’s operating revenue and 82% of operating income in the quarter ended September 24, 2004.
CSX Intermodal Inc.
CSX Intermodal Inc. (“CSXI”) is one of the nation’s largest transcontinental intermodal transportation service providers, operating a network of dedicated intermodal facilities across North America. The CSXI network runs approximately 500 dedicated trains between its 44 terminals weekly. CSXI accounted for 16% of CSX’s operating revenue and 12% of operating income for the quarter ended September 24, 2004. Its headquarters are located in Jacksonville, Florida. The rail and intermodal segments are viewed on a combined basis as Surface Transportation operations.
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CSX CORPORATION AND SUBSIDIARIESITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF RESULTSOF OPERATIONS AND FINANCIAL CONDITION
OVERVIEW, Continued
Surface Transportation
Surface Transportation, which includes CSX’s rail and intermodal units, generated revenue of $1.9 billion and $5.8 billion for the quarter and nine months ended September 24, 2004, respectively, compared to $1.8 billion and $5.5 billion for the quarter and nine months ended September 26, 2003, respectively. Operating income for Surface Transportation was $247 million and $678 million for the quarter and nine months ended September 24, 2004, respectively, compared to an operating loss of $16 million and operating income of $412 million for the quarter and nine months ended September 26, 2003.
During the third quarter of 2004, Surface Transportation revenue and volume increased over the prior year comparable quarter due to favorable economic conditions combined with yield management initiatives. Surface Transportation operating income was higher than the prior year comparable quarter by $263 million, as there was a third quarter 2003 charge of $229 million that was recorded in conjunction with the Company’s change in estimate for its casualty reserves.
In addition to reviewing various financial measures, CSX management uses non-financial indicators to monitor performance and operating efficiency of its network. Those include:
(a) Amounts for 2004 are estimated
The number of FRA-reportable train accidents per million train miles and the number of injuries per 100 employees both showed improvement in the third quarter of 2004 compared to the same period in 2003. Average train velocity decreased 4%. The average system dwell time, which measures the amount of time between car arrival and departure from yards, increased 13% from the third quarter of 2003 to 2004. The percent of scheduled trains departing the origin station at or prior to the scheduled departure time and the percent of scheduled trains arriving at the destination station within two hours of the scheduled arrival time showed the largest declines for the third quarter of 2004 versus the comparable prior period. The number of relief crews called per day on average also demonstrated an unfavorable variance, deteriorating over the prior year quarter, from 54.3 to 62.2.
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Surface Transportation, Continued
CSX’s non-financial service measures, including train velocity, equipment dwell and recrews, are indicators of network fluidity. Degradation of these measures, among other things, results in higher labor, equipment and locomotive costs. CSX management continues its efforts to improve operating performance and efficiency through a number of initiatives, including continued focus on safety processes and disciplined execution of the operating plan. CSX continues to invest in the key resources required to support strong demand for its services, including hiring additional train and engine employees and adding locomotives through purchase and short-term leasing.
During the third quarter, the CSX network experienced a series of severe storms and hurricanes, which negatively impacted revenue, cost, and network fluidity.
In 2004, the Company launched the ONE Plan initiative to improve operating efficiency and service levels. The initiative will redesign CSX’s operating plan for merchandise and automotive shipments, and will be implemented in two phases. The new operating plan will improve efficiency by reducing the number of terminal handlings and route miles required for each shipment. The first phase addresses the movement of shipments between processing yards. Implementation began in late June 2004 and rolled-out across the Company’s network through the 3rd quarter of 2004. All operating plan changes were in place by the end of August. Initial results were promising, but implementation was disrupted by a series of severe storms, which had an adverse impact on the entire CSX network. The Company continues to focus on executing the new operating plan and anticipates the realization of benefits in 2005. The second phase of the ONE Plan will address the local pick-up and delivery of shipments to customer locations.
International Terminals
CSX World Terminals LLC (“CSXWT”) operates container-freight terminal facilities in Asia, Europe, Australia, Latin America and the United States. CSXWT accounted for 2% of CSX’s operating revenues and 3% of operating income for the quarter ended September 24, 2004. CSXWT is headquartered in Charlotte, North Carolina.
CSXWT’s Hong Kong terminal accounted for approximately 59% of CSXWT’s revenues for the first nine months of 2004. The Hong Kong terminal showed a volume decrease of 20% for the third quarter, which corresponds with a 38% decrease in revenue versus the third quarter of 2003. Competitive pressures are rising as customers are shifting their traffic from facilities in Hong Kong to newly opened terminals in South China’s Guangdong region, resulting in reduced volumes and revenue. A significant customer of CSXWT terminated its marine terminal services contract during the first quarter of 2004, which negatively impacted CSXWT’s 2004 third quarter revenues by approximately $17 million. CSXWT anticipates 2004 annual revenues to decline by approximately $55 million as a result of this customer loss. In December 2004, another contract with a significant customer is scheduled to expire. CSXWT expects that it will be able to replace all or substantially all of the lost volume with new customers representing long and short-term commercial commitments. It is too early to establish a timeline under which these expectations will be met. In addition, due to the increased competitive pressures, it is possible that the profit margins achieved in the past will not be realized in the near term.
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International Terminals, Continued
CSX management is currently reviewing long-term performance improvement strategies as well as other strategic initiatives. Improvement strategies include expanding capacity and market reach, discontinuing unprofitable operations, improving productivity and replacing volumes and revenues at its Hong Kong facility. New operations have commenced in Caucedo, Dominican Republic and the Shandong Province of the People’s Republic of China. Terminal operations have been terminated in Rio Haina, Dominican Republic and trucking operations have been terminated in Hong Kong. Facility expansion and exit costs negatively impacted earnings through the first nine months of 2004.
CSXWT terminal productivity for the main terminals, defined as lifts per hour, for the quarters ended September 24, 2004 and September 26, 2003, was as follows. It should be noted that there was a decline in productivity in the Dominican Republic as operations shifted from an old terminal to the new terminal.
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RESULTS OF OPERATIONS
Quarter ended September 24, 2004 compared to quarter ended September 26, 2003
Consolidated Results
Operating Revenue
Despite a $17 million reduction of operating revenue in the International Terminals segment, consolidated operating revenue increased $98 million to $1.9 billion in the quarter ended September 24, 2004 primarily due to volume and price increases within Surface Transportation.
Operating Income
Operating income was $264 million for the quarter ended September 24, 2004, as compared to a loss of $98 million for the prior year comparable quarter. Operating expenses decreased $264 million to $1.7 billion for the quarter ended September 24, 2004. A discussion of operating expenses by business segment follows.
The Company recorded a charge of $232 million in the third quarter of 2003 to increase its provision for casualty reserves. The decline was primarily the result of the Company’s recording a charge in conjunction with changing its estimate of casualty reserves to include an estimate of incurred but not reported claims for asbestos and other occupational injuries to be received over the next seven years.
Additionally, in the third quarter of 2003, CSX entered into final settlement agreements resolving all material outstanding disputes with Maersk. This decreased operating income by $108 million, and is reflected in operating expense as the additional loss on sale of international container-shipping assets.
The remaining decline in operating income for the third quarter of 2003 was due to a $22 million decrease in operating income from the sale of a majority of CSX’s interest in CSX Lines during the first quarter of 2003 as previously discussed, and increased operating expenses at the Surface Transportation Segment, primarily due to increased materials, supplies and other costs and labor and fringe benefit expense.
Other Income (Expense)
Other income increased $4 million for the quarter ended September 24, 2004, as compared to the prior year comparable quarter, primarily due to the net gain on the Conrail spin-off transaction (See Note 6, Investment In and Integrated Rail Operation With Conrail), but partially offset by a decline in income from real estate and resort operations.
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RESULTS OF OPERATIONS, Consolidated Results, Continued
Interest Expense
Interest expense increased $3 million in the quarter ended September 24, 2004, as compared to the prior year comparable period due to decreased benefits from our interest rate swaps and the exchange of Conrail debt as a result of the Conrail spin-off transaction.
Net Earnings
CSX’s net earnings were $123 million, in the quarter ended September 24, 2004, compared to a net loss of $103 million for the same period of the prior year. The increase is due to strong surface transportation revenue and no significant charges were incurred in the quarter. The decreased operating expenses are partially attributable to the third quarter 2003 charge of $232 million that was recorded in conjunction with the Company’s change in estimate for its casualty reserves.
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Segment Results: The following tables provide detail of operating revenue and expense by segment:
(Dollars in Millions) (Unaudited) (a)Quarters Ended September 24, 2004 and September 26, 2003
Nine Months Ended September 24, 2004 and September 26, 2003
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RESULTS OF OPERATIONS, Continued
Surface Transportation Results
The following tables provide Surface Transportation carload and revenue data by service group and commodity:
SURFACE TRANSPORTATION TRAFFIC AND REVENUE(a)
Loads (Thousands); Revenue (Dollars in Millions)
Quarters Ended September 24, 2004 and September 26, 2003
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RESULTS OF OPERATIONS, Surface Transportation Results, Continued
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Rail
Rail revenue increased $106 million, or 7% in the quarter ended September 24, 2004, as compared to the quarter ended September 26, 2003.
Merchandise
Merchandise showed improved yield in the third quarter. Overall revenue was up 6% while volume declined 1%. Most markets showed year-over-year improvement in revenue and revenue-per-car due to continued yield management efforts and the Company’s fuel surcharge program.
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RESULTS OF OPERATIONS, Rail, Continued
Automotive
North American light vehicle production declined by approximately 69,000 units, or roughly 2%, year-over-year. Inventory levels remain high at 63 days for most manufacturers, 69 days for the Big 3. Ongoing rail service issues have also had an impact on base business and have hindered growth initiatives. In addition, hurricane disruptions negatively impacted Florida sales, hindering manufacturers’ efforts to reduce inventory.
Coal, Coke and Iron Ore
Coal, coke, and iron ore experienced 10% revenue growth on 4% volume growth. This was driven by significant volume and revenue gains in export, metallurgical, northern utilities and industrial markets. All lines of business reflect favorable year-over-year revenue-per-car gains. However, certain mines experienced flooding in the aftermath of Hurricane Ivan, which hampered production. Hurricanes further hampered service and volume growth.
Other
Other revenue for the third quarter 2004 includes $16 million for FRT, a short-line railroad consolidated in 2004 pursuant to FASB Interpretation No. 46,“Consolidation of Variable Interest Entities”. Prior to 2004, FRT was accounted for under the equity method.
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Operating Expense
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Operating income increased $261 million to $216 million for the quarter ended September 24, 2004, compared to a net loss of $45 million for the quarter ended September 26, 2003.
Intermodal
Intermodal operating expense increased $7 million, or 3%, compared to the prior year quarter, resulting primarily from an increase in terminal and trucking costs related to mix changes. Additionally, depreciation expense increased $2 million.
Intermodal operating income increased $2 million, or 7%, compared to the prior year quarter due to a reduction in incentive refunds and increased supplemental charges. Continued yield improvements in the domestic business segment are also driving the increase.
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International Terminals Results
Revenue decreased $17 million to $42 million for the third quarter of 2004, compared to $59 million in the third quarter of 2003, primarily due to the loss of a significant customer at its Hong Kong operations.
Operating expense decreased $5 million to $34 million for the third quarter of 2004, compared to $39 million in the third quarter of 2003. This is attributable to lower expenses due to decreased customer volume in Hong Kong, offset by a write-down of capitalized software.
Operating income decreased $12 million for the third quarter of 2004, as compared to the third quarter of 2003.
Nine months ended September 24, 2004 compared to nine months ended September 26, 2003
Consolidated operating revenue increased $136 million to $5.9 billion for the nine months ended September 24, 2004, despite decreased revenue in the International Terminals segment of $41 million.
Operating income was $716 million for the nine months ended September 24, 2004, as compared to $364 million for the prior year comparable period. Operating expenses decreased $216 million to $5.3 billion for the nine months ended September 24, 2004, primarily due to the provision for casualty claims charge taken in 2003.
Other Income
Other income decreased $13 million to $17 million for the nine months ended September 24, 2004, as compared to $30 million for the prior year comparable period, primarily due to a decline in income from real estate and resort operations. This decrease was partially off-set by the net gain of $16 million, after tax, related to the Conrail spin-off transaction. (See Note 6, Investment In and Integrated Rail Operation with Conrail)
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Interest expense increased $12 million for the nine months ended September 24, 2004, as compared to the prior year comparable period due to decreased benefits from our interest rate swaps and the exchange of Conrail debt, as a result of the Conrail spin-off transaction.
Net earnings for the nine months ended September 26, 2003 included a cumulative effect of an accounting change of $93 million, $57 million after tax, representing the reversal of the accrued liability for crosstie removal costs related to the adoption of SFAS 143, “Accounting for Asset Retirement Obligations”.
Earnings before the cumulative effect of accounting changes were $272 million, and $66 million for the nine months ended September 24, 2004 and September 26, 2003, respectively. During the first three quarters of 2004, increases in operating revenues and decreases in operating expenses, were partially offset by management restructuring charges of $77 million, higher interest expense, and lower income from real estate and resort operations.
The nine months ended September 26, 2003 included a cumulative effect of accounting change after tax benefit of $57 million, offset by a $145 million after tax, charge to increase the Company’s provision for casualty reserves and a $67 million after tax charge to record the loss on sale of international container-shipping assets.
The effective tax rate for the nine month period ending September 26, 2003 was lower than the Company’s historical effective tax rate due to a change in the mix of earnings to lower tax rate jurisdictions and a favorable adjustment to deferred state tax liabilities.
Divestitures
In February 2003, CSX conveyed most of its interest in its domestic container-shipping subsidiary, CSX Lines, to a new venture formed with the Carlyle Group for approximately $300 million (gross cash proceeds of approximately $240 million, $214 million net of transaction costs, and $60 million of securities). CSX Lines was subsequently renamed Horizon Lines LLC (“Horizon”). Horizon subleased vessels and equipment from certain affiliates of CSX covering the primary financial obligations related to $265 million of leases under which CSX and one of its affiliates will remain a lessee/sublessor or guarantor. A deferred pretax gain of approximately $127 million as a result of the transaction is being recognized over the 12-year sub-lease term. The securities have a term of 7 years and a preferred return feature. During the third quarter of 2003, CSX received a $15 million payment from Horizon, which included $3 million of interest, in return of a portion of its investment in Horizon. $226 million is shown as proceeds from divestiture in the investing section of the Consolidated Statement of Cash Flows and $3 million is included in net earnings. (See Note 4, Divestitures)
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In July 2004, Horizon was acquired by an unrelated third party, and CSX received $59 million, which included $48 million for the purchase of its ownership interest in Horizon, $4 million of interest, and a performance payment of $7 million, which will also be recognized over the 12-year sub-lease term. $55 million is shown as proceeds from divestiture in the investing section of the Consolidated Statement of Cash Flows and $4 million is included in net earnings. However, CSX and one of its affiliates will continue to remain a lessee/sublessor or guarantor on certain vessels and equipment as long as the subleases remain in effect. (See Note 13, Commitments and Contingencies.)
New Accounting Pronouncements and Cumulative Effect of Accounting Change
SFAS 143, “Accounting for Asset Retirement Obligations” was issued in 2001. This statement addresses financial accounting and reporting for legal obligations associated with the retirement of tangible long-lived assets and the associated retirement costs. In conjunction with the group-life method of accounting for asset costs, the Company historically accrued crosstie removal costs as a component of depreciation, which is not permitted under SFAS 143. With the adoption of SFAS 143 in fiscal year 2003, CSX recorded pretax income of $93 million, $57 million after tax, as a cumulative effect of an accounting change in the first quarter, representing the reversal of the accrued liability for crosstie removal costs. The adoption of SFAS 143 did not have a material effect on prior reporting periods, and will not have a material effect on future earnings.
SFAS 148, “Accounting for Stock-Based Compensation –Transition and Disclosure an amendment of SFAS 123” was issued in December 2002. SFAS 148 amends SFAS 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition to SFAS 123’s fair value method of accounting for stock-based employee compensation and require disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation. Effective beginning with fiscal year 2003, CSX voluntarily adopted the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation,” and adopted the disclosure requirements of SFAS 148. In accordance with the prospective method of adoption permitted under SFAS 148, stock-based awards issued subsequent to fiscal year 2002 are accounted for under the fair value recognition provisions of SFAS 123 utilizing the Black-Scholes valuation method and, accordingly, are expensed. (See Note 11, Stock Based Compensation)
In 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities,” which requires a variable interest entity (“VIE”) to be consolidated by a company that is subject to a majority of the risk of loss from the VIE’s activities or is entitled to receive a majority of the entity’s residual returns, or both. Under the new guidance, CSX consolidated Four Rivers Transportation, Inc. (“FRT”), a shortline railroad, into its financial statements at the beginning of fiscal 2004. Previously, FRT was accounted for under the equity method of accounting. The consolidation of FRT did not have a material impact on the Company’s financial statements.
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LIQUIDITY AND CAPITAL RESOURCES
Cash, cash equivalents and short-term investments increased $261 million to $629 million at September 24, 2004, from $368 million at December 26, 2003. Primary sources of cash and cash equivalents during the nine months ended September 24, 2004 include normal transportation operations supplemented by $400 million in floating rate notes and bank borrowings.
See Note 3, Debt and Credit Agreements, for discussion of the Company’s revolving credit agreements.
As of September 24, 2004, CSX Corporation’s long-term unsecured debt obligations were rated BBB and Baa2 by Standard and Poor’s and by Moody’s Investor Service, respectively. On March 30, 2004, Standard and Poor’s lowered the Company’s short-term rating from A-2 to A-3 and revised the outlook from stable to negative. This increases the Company’s borrowing costs in the commercial paper market and reduces the Company’s access to these funds because of the limited demand for A-3 commercial paper. On July 6, 2004, Moody’s Investor Service reaffirmed the Company’s short and long-term unsecured debt ratings, but adjusted the outlook from stable to negative. If CSX’s long-term unsecured bond ratings were reduced to BBB- and Baa3, the Company’s undrawn borrowing costs under the $1.2 billion and $400 million revolving credit facilities would not materially increase. At September 24, 2004, the Company had no borrowings outstanding under these credit facilities. The Company’s short-term commercial paper program is rated A-3 and P-2 by Standard and Poor’s and Moody’s Investor Service, respectively.
The Company had no commercial paper borrowings outstanding at September 24, 2004 or December 26, 2003.
Outstanding debt obligations of $300 million matured on August 23, 2004. The Company settled these obligations with cash and short-term investments on hand.
CSX’s working capital at September 24, 2004 was $298 million, compared to a deficit of $307 million at December 26, 2003. This change is primarily driven by an increase of cash, cash equivalents, short-term investments, and a decrease in debt that will become due within 12 months. The Company believes that in future periods working capital will return to a deficit. A working capital deficit is not unusual for the Company and other companies in the industry and does not indicate a lack of liquidity. The Company continues to maintain adequate current assets to satisfy current liabilities and maturing obligations when they come due and has sufficient financial capacity to manage its day-to-day cash requirements and any obligations arising from legal, tax and other regulatory rulings.
Shelf Registration Statements
CSX currently has $900 million of capacity under an effective shelf registration that may be used, subject to market conditions and board authorization, to issue debt or equity securities at the Company’s discretion. The Company presently intends to use the proceeds from the sale of any securities issued under its shelf registration statement to finance cash requirements, including refinancing existing debt as it matures. While the Company seeks to give itself flexibility with respect to meeting such needs, there can be no assurance that market conditions would permit the Company to sell such securities on acceptable terms at any given time, or at all.
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LIQUIDITY AND CAPITAL RESOURCES, Continued
FINANCIAL DATA
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INVESTMENT IN AND INTEGRATED RAIL OPERATIONS WITH CONRAIL
See Background, Accounting and Financial Reporting Effects and Summary Financial Information in Note 6, Investment In and Integrated Rail Operations with Conrail.
Conrail’s Results of Operations
Conrail reported net income of $33 million in the third quarter of 2004, compared to $42 million in the prior year third quarter. Operating revenues decreased $41 million to $187 million for the quarter ended September 24, 2004, while operating expenses decreased $20 million for the same period.
As previously reported, in June 2003 CSX, Norfolk Southern Corporation (“NS”), and Conrail Inc. (“Conrail”) jointly filed a petition with the Surface Transportation Board (“STB”) to establish direct ownership and control by CSX’s and NS’ respective subsidiaries, CSX Transportation, Inc. (“CSXT”) and Norfolk Southern Railway Company (“NSR”), of CSX’s and NS’ portions of the Conrail system already operated by them separately and independently under various agreements. These portions of the Conrail system were owned by Conrail’s subsidiaries, New York Central Lines, LLC (“NYC”) and Pennsylvania Lines, LLC (“PRR”). In August 2004, the following events occurred: (i) the ownership o NYC and PRR was transferred to CSXT and NSR, respectively, and (ii) CSXT consummated an exchange offer of new unsecured securities of subsidiaries of CSXT and NSR for unsecured securities of Conrail. The exchange offer was the final stage in the restructuring of Conrail’s unsecured indebtedness as described in the parties joint petition filed with the STB.
CSXT and NSR offered unsecured debt securities of newly formed subsidiaries in an approximate 42%/58% ratio in exchange for Conrail’s unsecured debentures. The debt securities issued by each respective subsidiary were fully and unconditionally guaranteed by CSXT and NSR. Upon completion of the transaction, the subsidiaries merged into CSXT and NSR, respectively, and the new debt securities thus became direct unsecured obligations of CSXT and NSR. Conrail’s secured debt and lease obligations remained obligations of CSXT or NSR. Conrail’s secured debt and lease obligations of Conrail and are supported by new leases and subleases which became the direct lease and sublease obligations, also in an approximate 42%/58% ratio, of CSXT and NSR.
Prior to the transaction, CSX’s and NS’ indirect ownership interest in NYC and PRR mirror their ownership interest in Conrail (42% for CSX and 58% for NS). Subsequent to the transaction, CSX obtained direct ownership of all NYC and NS obtained direct ownership PRR. Thus, CSX in effect received NS’ 58% indirect ownership in NYC and NS in effect received CSX’s 42% indirect ownership of PRR. The receipt of the interests not already indirectly owned by CSX was accounted for at fair value. The receipt of the NYC interest already indirectly owned by CSX was accounted for using CSX’s basis in amounts already included within CSX’s investment in Conrail.
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OTHER MATTERS
Critical Accounting Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires that management make estimates in reporting the amounts of certain assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of certain revenues and expenses during the reporting period. Actual results may differ from those estimates. Significant estimates using management judgment are made for the following areas:
These estimates and assumptions are discussed with the Audit Committee of the Board of Directors on a regular basis. For information regarding CSX’s significant estimates using management judgment, see Management’s Discussion and Analysis of the Results of Operations in the Company’s Form 10-K for the year ended December 26, 2003.
Matters Arising from Sale of International Container-Shipping Assets
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OTHER MATTERS, Continued
Principal Accountant Services
Our independent auditor, Ernst & Young LLP (“E&Y”) recently notified the SEC, the Public Company Oversight Board, and the Audit Committee of our Board of Directors that certain non-audit services E&Y performed in China for a large number of public Companies, including CSX, have raised questions regarding E&Y’s independence in its performance of audit services.
With respect to CSX, from January 1996 through June 2003, E&Y performed tax calculation and preparation services for CSX employees located in China (4 employees during the applicable period), and E&Y’s affiliated firm in China made payments of the relevant taxes on behalf of two unconsolidated CSX affiliates. In addition, E&Y prepared business tax and corporate income tax returns and arranged for a one-time payment on behalf of an unconsolidated CSX affiliate in October of 2002. The payments of those taxes involved handling of Company related funds, which is not permitted under SEC auditor independence rules. These actions by affiliates of E&Y have been discontinued, and both the amount of the taxes and fees paid to E&Y in connection with these services are de minimis.
The Audit Committee and E&Y discussed E&Y’s independence with respect to the Company in light of the foregoing facts. E&Y informed the Audit Committee that it does not believe that the holding and paying of those funds impaired E&Y’s independence with respect to the Company. The Company, based on its own review, also is not aware of any additional non-audit services that may compromise E&Y’s independence in performing audit services for the Company. The Audit Committee and the Company have considered the impacts of the actions by the affiliates of E&Y, and have independently concluded that these actions do not have an impact of E&Y’s independence.
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FORWARD LOOKING STATEMENTS
This quarterly report contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act with respect to, among other items:
Forward-looking statements are typically identified by words or phrases such as “believe”, “expect”, “anticipate”, “project”, and similar expressions. The Company cautions against placing undue reliance on forward-looking statements, which reflect its current beliefs and are based on information currently available to it as of the date the forward-looking statement is made. The Company undertakes no obligation to update or revise any forward-looking statement. If the Company does update any forward-looking statement, no inference should be drawn that the Company will make additional updates with respect to that statement or any other forward-looking statements.
Forward-looking statements are subject to a number of risks and uncertainties, and actual performance or results could differ materially from that anticipated by these forward-looking statements. Factors that may cause actual results to differ materially from those contemplated by these forward-looking statements include, among others:
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FORWARD LOOKING STATEMENTS, Continued
Other important assumptions and factors that could cause actual results to differ materially from those in the forward-looking statements are specified elsewhere in this Quarterly Report and in the Company’s other SEC reports, accessible on the SEC’s website at www.sec.gov and the Company’s website at www.csx.com.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
CSX addresses market risk exposure to fluctuations in interest rates and the risk of volatility in its fuel costs through the use of derivative financial instruments. The Company does not hold or issue derivative financial instruments for trading purposes.
The Company addresses its exposure to interest rate market risk through a controlled program of risk management that includes the use of interest rate swap agreements. As of September 24, 2004, the Company had various interest rate swap agreements on $950 million of its outstanding notes payable. In the event of a 1% increase or decrease in the LIBOR interest rate, the interest expense related to these agreements would increase or decrease approximately $10 million on an annual basis.
During 2003, the Company began a program to hedge its exposure to fuel price volatility through swap transactions. As of September 24, 2004, CSX had hedged approximately 40%, 46%, and 12% of fuel purchases for 2004, 2005, and 2006, respectively. At September 24, 2004, a 1% change in fuel prices would result in an increase or decrease in the asset related to the swaps of approximately $5 million. The Company’s rail unit average annual fuel consumption is approximately 615 million gallons. A one-cent change in the price per gallon of fuel would affect fuel expense by approximately $5 million annually.
The Company is exposed to loss in the event of non-performance by any counter-party to the interest rate swap or fuel hedging agreements. The Company does not anticipate non-performance by such counter-parties, and no material loss would be expected from non-performance.
Exclusive of derivative contracts that swap fixed interest rate notes to floating interest rates, CSX had approximately $603 million of floating rate debt outstanding at September 24, 2004. A 1% variance in interest rates would on average affect annual interest expense by approximately $6 million.
While the Company’s international terminals segment does business in several foreign countries, a substantial portion of its revenue and expenses are transacted in U.S. dollars, or currencies with little fluctuation against the U.S. dollar. For this reason, CSX does not believe its foreign currency market risk is significant.
A substantial increase in the fair market value of the Company’s stock price could negatively impact earnings per share due to the dilutive effect of stock options and convertible debt.
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CSX CORPORATION AND SUBSIDIARIESITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
ITEM 4. CONTROLS AND PROCEDURES
As of September 24, 2004, under the supervision and with the participation of the Company’s Chief Executive Officer (“CEO”) and the Chief Financial Officer (“CFO”), management has evaluated the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the CEO and CFO concluded that the Company’s disclosure controls and procedures were effective as of September 24, 2004. There were no changes in the Company’s internal controls over financial reporting during the fiscal quarter covered by this quarterly report that have materially affected or are reasonably likely to materially affect the Company’s internal control over financial reporting.
PART II: OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
For information relating to CSX’s settlements and other legal proceedings, see Note 13.
ITEM 2: UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
NONE.
ITEM 3: DEFAULTS UPON SENIOR SECURITIES
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ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
ITEM 5: OTHER INFORMATION
ITEM 6. EXHIBITS
Exhibits
• Filed herewith
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: November 3, 2004
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