CSX Corporation - 10-Q quarterly report FY

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of September 27, 2002: 213,030,402 shares.

In the opinion of management, the accompanying consolidated financial statements contain all adjustments necessary to present fairly the financial position of CSX Corporation and subsidiaries (“CSX” or the “Company”) at September 27, 2002 and December 28, 2001, the results of its operations for the quarters and nine months ended September 27, 2002 and September 28, 2001, and its cash flows for the nine months ended September 27, 2002 and September 28, 2001, such adjustments being of a normal recurring nature. Certain prior-year data have been reclassified to conform to the 2002 presentation.

The Company believes that the disclosures presented are accurate and not misleading, but suggests that these financial statements be read in conjunction with the financial statements and the notes included in the Company’s latest Annual Report and Form 10-K.

CSX follows a 52/53 week fiscal reporting calendar. Fiscal years 2002 and 2001 consist of 52 weeks ending on December 27, 2002 and December 28, 2001, respectively. The financial statements presented are for the 13-week quarters ended September 27, 2002 and September 28, 2001, the 39-week periods ended September 27, 2002 and September 28, 2001, and as of December 28, 2001.

Comprehensive income approximates net earnings for all periods presented in the accompanying consolidated statement of earnings.

Earnings per share are based on the weighted-average number of common shares outstanding for the fiscal quarters and nine months ended September 27, 2002 and September 28, 2001. Earnings per share, assuming dilution, are based on the weighted-average number of common shares outstanding adjusted for the effect of potential common shares outstanding during the period, principally arising from employee stock plans. Share information for the fiscal quarters and nine months ended September 27, 2002 and September 28, 2001 is as follows:

Certain potential common shares outstanding at September 27, 2002 and September 28, 2001 were not included in the computation of earnings per share, assuming dilution, since their exercise or conversion prices were greater than the average market price of the common shares during the period and, accordingly, their effect is antidilutive. These shares totaled 33.8 million at a weighted-average exercise price of $46.32 per share at September 27, 2002 and 18.8 million with a weighted-average exercise price of $43.38 per share at September 28, 2001. 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.

In 2001, Statement of Financial Accounting Standard (SFAS) No. 142, “Goodwill and Other Intangible Assets,” was issued. Under the provisions of SFAS 142, goodwill and other indefinite-lived intangible assets are no longer amortized but are reviewed for impairment on a periodic basis. The Company adopted this standard in the first quarter of 2002 and incurred a charge of $83 million, $43 million after tax and consideration of minority interest, 20 cents per share as a cumulative effect of an accounting change, which represents the difference between book value and the fair value of indefinite lived intangible assets. These indefinite-lived intangible assets are permits and licenses that the Company holds relating to a proposed pipeline to transfer natural gas from Alaska’s north slope to the port in Valdez, Alaska. The fair value was determined using a discount method of projected future cash flows relating to these assets. The carrying value of these assets is now approximately $3 million. The adoption of SFAS 142 did not have a material effect on prior reporting periods, and will not have a material effect on future earnings. The Company does not have any other indefinite lived intangible assets.

CSX and Norfolk Southern Corporation (“Norfolk Southern”) completed the acquisition of Conrail, Inc. (“Conrail”) in May 1997. Conrail owns the primary freight railroad system serving the northeastern United States, and its rail network extends into several midwestern states and into Canada. CSX and Norfolk Southern, through a jointly owned acquisition entity, hold ownership interests in Conrail of 42% and 58%, respectively, and voting interests of 50% each. CSX and Norfolk Southern operate over allocated portions of the Conrail lines.

The rail subsidiaries of CSX and Norfolk Southern operate their respective portions of the Conrail system pursuant to certain operating agreements. Under these agreements, the railroads pay operating fees to Conrail for the use of right-of-way and rent for the use of equipment. Conrail continues to provide rail service in certain shared geographic areas (“Shared Asset Areas”) for the joint benefit of CSX and Norfolk Southern for which it is compensated on the basis of usage by the respective railroads.

CSX’s rail and intermodal operating revenue and expense includes activity from traffic moving on the territory acquired in the Conrail transaction. Rail operating expenses include an expense category, “Conrail Operating Fee, Rent and Services,” which reflects payments to Conrail for the use of right-of-way and equipment, as well as charges for transportation, switching, and terminal services in the Shared Asset Areas that Conrail operates for the joint benefit of CSX and Norfolk Southern. This expense category also includes amortization of the fair value write-up arising from the acquisition of Conrail, as well as CSX’s proportionate share of Conrail’s net income or loss recognized under the equity method of accounting.

Summary financial information for Conrail for its fiscal periods ended September 30, 2002 and 2001, and at December 31, 2001, is as follows:

The agreement under which CSX operates its allocated portion of the Conrail route system has an initial term of 25 years and may be renewed at CSX’s option for two five-year terms. Operating fees paid to Conrail under the agreement are subject to adjustment every six years based on the fair value of the underlying Conrail railroad system. Lease agreements for the Conrail equipment operated by CSX cover varying terms. CSX is responsible for all costs of operating, maintaining, and improving the routes and equipment under these agreements.

As listed below, CSX has amounts payable to Conrail, representing expenses incurred under the operating, equipment and shared area agreements with Conrail. At December 28, 2001, CSX also had receivables from Conrail, principally for reimbursement of certain capital improvement costs. Conrail advances its available cash balances to CSX and Norfolk Southern under variable-rate notes, with CSX’s note maturing on March 28, 2007.

Interest expense relating to the Conrail advances for the quarter and nine months ended September 27, 2002 was $2.0 million and $5.8 million, respectively. Interest expense for the quarter and nine months ended September 28, 2001 was $1.7 and $4.0, respectively.

The Company sells revolving interests in its rail accounts receivable to public investors through a securitization program and to financial institutions through commercial paper conduit programs. The accounts receivable are sold, without recourse, to a wholly-owned, special-purpose subsidiary, which then transfers the receivables, with recourse, to a master trust. The securitization and conduit programs are accounted for as sales in accordance with SFAS 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Receivables sold under these arrangements are excluded from accounts receivable in the consolidated statement of financial position. At September 27, 2002, the agreements provide for the sale of up to $350 million in receivables through the securitization program and $200 million through the conduit program.

During the quarter ended September 27, 2002, the Company discontinued the sale of $120 million of accounts receivable included in the master trust, resulting in a $120 million increase in accounts receivable. The certificates issued under the securitization program bear interest at 6% annually and mature in June 2003. Receivables sold under the conduit program, which expires in December 2002, require yield payments based on prevailing commercial paper rates (1.92% at September 27, 2002) plus incremental fees. The Company’s retained interest in the receivables in the master trust were approximately $557 million and $466 million at September 27, 2002 and December 28, 2001, and are included in accounts receivable. Losses recognized on the sale of accounts receivable totaled $6 million and $20 million for the quarter and nine months ended September 27, 2002, respectively, and $8 million and $27 million for the quarter and nine months ended September 28, 2001, respectively.

The Company has retained the responsibility for servicing accounts receivable transferred to the master trust. The average servicing period is approximately one month. No servicing asset or liability has been recorded since fees the Company receives for servicing the receivables approximate the related costs.

The Company maintains an allowance for doubtful accounts based upon the expected collectibility of accounts receivable including receivables transferred to the master trust. Allowances for doubtful accounts of $139 million and $100 million have been applied as a reduction of accounts receivable at September 27, 2002 and December 28, 2001, respectively.

On March 8, 2002, the Company issued $400 million aggregate principal amount of 6.30% notes due 2012. Proceeds of the notes were applied in the refinancing of $450 million of debentures that matured in May 2002. During the nine months ended September 27, 2002, the Company issued commercial paper in the amount of $574 million at a weighted average rate of 1.92%. These borrowings were primarily used to make scheduled payments of long-term debt.

During the nine months ended September 27, 2002, the Company exchanged a $225 million note payable to Conrail for a new long-term note. Additionally, the note payable was increased by $119 million, for a total of $344 million. The note matures on March 28, 2007, and has been appropriately classified as long-term debt. (See Note 4)

CSX has entered into interest rate swap agreements on the following fixed rate notes:

These agreements were entered for interest rate risk exposure management purposes and mature at the time the related notes are due. Under these agreements, the Company will pay variable interest based on LIBOR in exchange for fixed rate payments (on September 27, 2002 the variable and fixed rate weighted averages were 5.02% and 7.62%, respectively), effectively transforming the notes to floating rate obligations. Accordingly, the instruments qualify, and are designated, as fair value hedges.

For derivative instruments that are designated and qualify as a fair value hedge, the gain or loss on the derivative instrument, as well as the offsetting loss or gain on the hedged item attributable to the hedged risk, are recognized in current earnings during the period of change in fair values. The accounting for hedge effectiveness is measured at least quarterly based on the relative change in fair value between the derivative contract and the hedged item over time. 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 and prior year periods. Long-term debt has been increased $78 million and decreased $26 million for the fair market value of the interest rate swap agreements at September 27, 2002 and December 28, 2001, 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 liabilities or assets. Cash flows related to interest rate swap agreements are classified as “Operating Activities” in the Consolidated Statement of Cash Flows. For the quarter and nine months ended September 27, 2002, the Company reduced interest expense by approximately $8 million and $24 million, respectively, as a result of the interest rate swap agreements that were in place during that period. For the quarter and nine months ended September 28, 2001, interest expense was reduced by approximately $1 million.

The Company is exposed to credit loss in the event of nonperformance by the other parties to the interest rate swap agreements. However, the Company does not anticipate nonperformance by the counterparties.

The Company has entered into fuel purchase agreements for approximately 50% of its fuel requirements over the next three months. The Company has not entered into any fuel purchase agreements for 2003. At September 27, 2002, the agreements amount to approximately 70 million gallons in commitments at a weighted average of 78 cents per gallon. These contracts require the Company to take monthly delivery of specified quantities of fuel at a fixed price.

The Company also has a commitment under a long-term maintenance program for approximately 40% of the fleet of locomotives of CSX Transportation, Inc. (CSXT), a subsidiary of CSX. The agreement expires in 2025 and totals $2.6 billion.

The Company obtains substantial amounts of commercial insurance for potential losses for third-party liability and property damages. It also self-insures at reasonable levels, based on its assessment of market risks and practices.

CSX incurs claims for occupational injuries, personal injuries and accidents. Casualty reserves are estimated based upon the first reporting of an accident or personal injury, and updated as information develops. Liabilities for accidents are based upon the type and severity of the injury or claim and current trends and historical data. The Company believes it has recorded liabilities in sufficient amounts to cover all identified claims and estimates of incurred, but not reported personal injury and accident claims. Unreported occupational injuries are not subject to reasonable estimation, thus no provision is made for incurred, but not reported occupational injuries. Occupational injury, personal injury and accident liabilities amount to $633 million and $666 million at September 27, 2002 and December 28, 2001, respectively.

CSXT is a party to various proceedings involving private parties and regulatory agencies related to environmental issues. CSXT has been identified as a potentially responsible party (PRP) at 89 environmentally impaired sites that 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. Such proceedings arising under Superfund or similar state statutes can involve numerous other waste generators and disposal companies and seek to allocate or recover costs associated with site investigation and cleanup, which could be substantial.

CSXT is involved in a number of administrative and judicial proceedings and other clean-up efforts at 206 sites. The 206 sites where it is participating in the study or clean-up of alleged environmental contamination include the 89 Superfund sites described above.

At least once each quarter, CSXT reviews its role, if any, with respect to each such location, giving consideration to the nature of CSXT’s alleged connection to the location (e.g., generator of waste sent to the site, 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 of evidence connecting CSXT to the location, and the number, connection, financial position and ability to pay of other named and unnamed PRPs at the location.

Based upon the assessment review process, CSXT has recorded, and reviews at least quarterly for adequacy, reserves to cover estimated contingent future environmental costs with respect to such sites. The recorded liabilities for estimated future environmental costs at September 27, 2002, and December 28, 2001 were $34 and $32 million, respectively. These recorded liabilities, which are undiscounted, include amounts representing CSXT’s estimate of unasserted claims, which CSXT believes to be immaterial. The liability has been accrued for future costs for all sites where the Company’s obligation is probable and where such costs can be reasonably estimated. 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 27, 2002 environmental liability is expected to be paid out over the next five to seven years, funded by cash generated from operations.

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 reliably estimated. Based upon information currently available, however, the Company believes its environmental reserves are adequate to accomplish remedial actions to comply with present laws and regulations, and that the ultimate liability for these matters will not materially affect its overall results of operations and financial condition.

In December 1999, CSX sold certain assets comprising Sea-Land’s international liner business to A. P. Moller-Maersk Line (Maersk). Maersk acquired vessels, containers, certain terminal facilities and various other assets and related liabilities of the international liner business. The agreement with Maersk provided for a post-closing working capital adjustment to the sales price based on the change in working capital, as defined in the agreement, between June 25, 1999, and December 10, 1999. The Company has recorded a receivable of approximately $70 million in connection with the post-closing working capital adjustment, and this amount is currently in dispute. This matter, together with certain other issues relating to contractual obligations of the Company relating to the sale of international container shipping assets, has been submitted to arbitration.

In addition to the disputes relating to the sale of the international container shipping assets, CSX has received a claim amounting to approximately $180 million plus interest from Europe Container Terminals bv (ECT), owner of the Rotterdam Container Terminal operated by Sea-Land prior to its sale to Maersk. ECT has claimed that the sale of the international liner business to Maersk resulted in a breach of the Sea-Land terminal agreements. ECT has refused to accept containers at the former Sea-Land facility tendered by Maersk and is seeking compensation from CSX related to the alleged breach. CSX has advised Maersk that CSX will hold it responsible for any damages that may result from this dispute. An initial arbitration hearing has been held to establish whether CSX is liable for ECT’s claim, and a ruling on that issue is expected in December 2002. Management believes that valid defenses to this claim exist. If the arbitration panel determines that there is liability, a separate hearing will be set to fix the amount of any damages.

Although management believes it will prevail in some or all of the Maersk and ECT disputes and arbitrations, it can give no assurance in this regard. An adverse outcome could have a material effect on the determination of the final loss on sale of Sea-Land’s International Liner business and the financial results in future reporting periods.

CSXT’s settlement of the New Orleans Tank Car Fire Litigation was $220 million, of which approximately $135 million was funded by CSXT’s insurers, and was paid during the third quarter of 2002 to the plaintiffs’ representatives.

In July, the Company received $44 million as the first of two payments to settle a contract dispute. In the quarter ended September 27, 2002, the Company recognized approximately $7 million of this first payment in other income as this amount related to prior periods. The remaining $37 million will be recognized ratably over the contract period, which ends in 2020. The second payment of $23 million is due in January 2003 and will be recognized over the contract period which ends in 2020. The results of this settlement will provide approximately $3 million in annual pretax earnings through 2020.

A number of other legal actions are pending against CSX and certain subsidiaries in which claims are made in substantial amounts. While the ultimate results of these legal actions cannot be predicted with certainty, management does not currently expect that the resolution of these matters will have a material effect on CSX’s consolidated financial position, results of operations or cash flows. 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 quarter received.

The Company operates in four business segments: Rail, Intermodal, Domestic Container Shipping, 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 transcontinental intermodal transportation services and operates a network of dedicated intermodal facilities across North America. The Domestic Container Shipping segment consists of a fleet of 17 ocean vessels and 22,000 containers serving the trade between ports on the United States mainland and Alaska, Guam, Hawaii and Puerto Rico. The International Terminals segment operates container freight terminal facilities in Hong Kong, China, Australia, Europe, Russia and Latin America. The Company’s segments are strategic business units that offer different services and are managed separately based on the differences in these services. Because of their close interrelationship, the Rail and Intermodal segments are viewed on a combined basis as Surface Transportation operations and the Domestic Container Shipping and International Terminals segments are viewed on a combined basis as Marine Services 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) in the CSX 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 in CSX’s consolidated financial statements to other expense. Intersegment sales and transfers are generally accounted for as if the sales or transfers were to third parties, at current market prices.

Business segment information for the quarters and nine months ended September 27, 2002 and September 28, 2001 is as follows:

A reconciliation of the totals reported for the business segments to the applicable line items in the consolidated financial statements is as follows:

During 1987, CSX Lines entered into agreements to sell and lease back by charter three new U.S.-built, U.S.-flag, D-7 class container ships. 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 Securities and Exchange Commission (“SEC”). The September 27, 2002, September 28, 2001, and December 28, 2001 consolidating schedules reflect CSX Lines as the obligor. In accordance with SEC disclosure requirements, consolidating financial information for the parent and obligor are as follows (amounts in millions):