UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q

 

 

 

Commission File Number 1-4717

 

 

KANSAS CITY SOUTHERN

(Exact name of registrant as specified in its charter)

 

 

 

 

816.983.1303

(Registrant’s telephone number, including area code)

 

 

None

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

 

 

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.  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

 

 

Kansas City Southern
Form 10-Q
June 30, 2008

 

Index

 

Kansas City Southern

 

Form 10-Q
June 30, 2008

 

 

The Consolidated Financial Statements included herein have been prepared by Kansas City Southern, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). As used herein, “KCS” or the “Company” may refer to Kansas City Southern or, as the context requires, to one or more subsidiaries of Kansas City Southern. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) have been condensed, or omitted pursuant to such rules and regulations. The Company believes that the disclosures are adequate to enable a reasonable understanding of the information presented. These Consolidated Financial Statements should be read in conjunction with the consolidated financial statements and the related notes, as well as Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-Q. Results for the three and six months ended June 30, 2008, are not necessarily indicative of the results expected for the full year ending December 31, 2008.

Kansas City Southern

 

Consolidated Statements of Income

 

 

See accompanying notes to consolidated financial statements.

Kansas City Southern

 

Consolidated Balance Sheets

 

 

See accompanying notes to consolidated financial statements.

Kansas City Southern

 

Consolidated Statements of Cash Flows

 

 

See accompanying notes to consolidated financial statements.

Kansas City Southern

 

Notes to Consolidated Financial Statements

 

 

In the opinion of the management of KCS, the accompanying unaudited consolidated financial statements contain all adjustments necessary, which are of a normal and recurring nature, to present fairly the financial position of the Company as of June 30, 2008, and December 31, 2007, the results of operations for the three and six months ended June 30, 2008 and 2007, and cash flows for the six months ended June 30, 2008 and 2007. Certain information and footnote disclosure normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted. These consolidated financial statements should be read in conjunction with the financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007. The results of operations for the three and six months ended June 30, 2008, are not necessarily indicative of the results to be expected for the full year ending December 31, 2008. Certain prior year amounts have been reclassified to conform to the current year presentation.

 

 

As the Kansas City Southern 1991 Amended and Restated Stock Option and Performance Award Plan was set to expire on July 14, 2008, on July 1, 2008, the executive committee of the board of directors approved and adopted a three-month extension to the term until October 14, 2008. The executive committee also approved on July 1, 2008, a new 2008 Stock Option and Performance Award Plan, which is effective October 14, 2008 and will be submitted to the Company’s stockholders for approval at a special KCS stockholder meeting to be held on October 7, 2008.

 

Nonvested Stock.  The Kansas City Southern 1991 Amended and Restated Stock Option and Performance Award Plan provides for the granting of nonvested stock awards to officers and other designated employees. The grant date fair value is based on the average market price of the stock on the date of the grant. These awards are subject to forfeiture if employment terminates during the vesting period, which is generally five year cliff vesting for employees and one year for non-employee directors. The grant date fair value of nonvested shares, less estimated forfeitures, is recorded to compensation expense on a straight-line basis over the vesting period.

 

A summary of nonvested stock activity is as follows:

 

 

Compensation cost on nonvested stock was $0.3 million and $1.7 million for the three months ended June 30, 2008 and 2007, and $1.8 million and $3.3 million for the six months ended June 30, 2008 and 2007, respectively. The total income tax benefit recognized in the income statement for nonvested stock awards was $0.1 million and $0.6 million for the three months ended June 30, 2008 and 2007, and $0.6 million and $1.2 million for the six months ended June 30, 2008 and 2007, respectively.

 

As of June 30, 2008, $15.9 million of unrecognized compensation costs related to nonvested stock is expected to be recognized over a weighted-average period of 1.61 years. The fair value (at vest date) of shares vested during the six months ended June 30, 2008 was $4.7 million.

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

Performance Based Awards.  During 2007, the Company granted performance based nonvested stock awards. The awards granted establish an annual target number of shares that generally vest at the end of a three year requisite service period following the grant date. In addition to the three year service condition, the number of nonvested shares to be received depends on the attainment of performance goals based on the following annual measures: operating ratio, earnings before interest, tax, depreciation and amortization (EBITDA) and return on capital employed. The number of nonvested shares ultimately earned will range from zero to 200% of the annual target award.

 

A summary of performance based nonvested awards activity at target is as follows:

 

 

 

 

The Company expenses the grant date fair value of the awards which are probable of being earned based on forecasted annual performance goals over the three year performance period. Compensation benefit on performance based awards was $0.3 million, net of taxes of $0.1 million, for the three months ended June 30, 2008. Compensation expense for the three months ended June 30, 2007 was $0.7 million, net of taxes of $0.3 million. Compensation expense of $1.3 million, net of taxes of $0.5 million, was recognized for the six months ended June 30, 2008 and 2007, respectively.

 

As of June 30, 2008, $2.6 million of unrecognized compensation cost related to performance based awards is expected to be recognized over a weighted-average period of .82 years. The unrecognized compensation cost includes only the amount determined to be probable of being earned based upon the attainment of the annual performance goals. The fair value (at vest date) of shares vested during the six months ended June 30, 2008 was $1.4 million.

 

 

Basic earnings per common share is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Restricted stock granted to employees and officers is included in weighted average shares for purposes of computing basic earnings per common share as it is earned. Diluted earnings per share reflect the potential dilution that could occur if convertible securities were converted into common stock or stock options were exercised. The following reconciles the weighted average shares used for the basic earnings per share computation to the shares used for the diluted earnings per share computation (in thousands):

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

Potentially dilutive shares excluded from the calculation (in thousands):

 

 

The following reconciles net income available to common stockholders for purposes of basic earnings per share to net income available to common stockholders for purposes of diluted earnings per share (in millions):

 

 

 

In September 2006, the Financial Accounting Standards Board (the “FASB”) issued Statement of Financial Accounting Standards No. 157 “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value and enhances disclosures regarding fair value measurements. SFAS 157 does not require any new fair value measurements but rather eliminates inconsistencies in guidance found in various prior accounting pronouncements and is effective for fiscal years beginning after November 15, 2007. In February 2008, the FASB issued FASB FSP 157-2 which delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. These nonfinancial items include assets and liabilities such as reporting units measured at fair value in a goodwill impairment test and nonfinancial assets acquired and liabilities assumed in a business combination. Effective January 1, 2008, KCS adopted SFAS 157 prospectively for financial assets and liabilities recognized at fair value on a recurring basis. The partial adoption of SFAS 157 for financial assets and liabilities did not have a material impact on its consolidated financial position, results of operations or cash flows.

 

SFAS 157 Hierarchy Tables.  The following tables present information about the Company’s financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2008, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

significance of a particular input to the fair value in its entirety requires judgment and considers factors specific to the asset or liability.

 

Assets and liabilities measured at fair value on a recurring basis as of June 30, 2008 (in millions):

 

 

 

 

The following table presents additional information about assets and liabilities measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value.

 

Changes in Level 3 assets measured at fair value on a recurring basis for the three months ended June 30, 2008 (in millions):

 

 

Changes in Level 3 assets measured at fair value on a recurring basis for the six months ended June 30, 2008 (in millions):

 

 

 

The Company does not engage in the trading of derivative financial instruments except where the Company’s objective is to manage fuel price risk, foreign currency fluctuations, and the variability of forecasted interest payments attributable to changes in interest rates. In general, the Company enters into derivative transactions in limited situations based on management’s assessment of current market conditions and perceived risks. However, management intends to respond to evolving business and market conditions and in doing so, may enter into such transactions more frequently as deemed appropriate.

 

Forward starting interest rate swap.  On March 18, 2008, the Company entered into a forward starting interest rate swap, which has been designated as a cash flow hedge under the Statement of Financial Accounting Standards No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”). The forward starting interest rate swap effectively converts interest payments from variable rates to fixed rates. This swap is highly effective and as a result there will be de minimus income statement variability associated

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

with ineffectiveness of the hedge. The hedging instrument has a notional amount of $75.0 million and forward starting settlements indexed off the three-month London InterBank Offered Rate (“LIBOR”) will occur every quarter beginning June 28, 2008 through March 28, 2011.

 

At June 30, 2008, the estimated fair value of the forward starting interest rate swap was $2.2 million and was included in other assets in the consolidated balance sheet.

 

Foreign Exchange Contracts.  The purpose of the foreign exchange contracts of Kansas City Southern de México, S.A. de C.V., a wholly-owned subsidiary of the Company (“KCSM”), is to limit exposure arising from exchange rate fluctuations in its Mexican peso-denominated financial assets and liabilities. Management determines the nature and quantity of any hedging transactions based upon net asset exposure and market conditions. As of June 30, 2008 and 2007, KCSM did not have any outstanding call option contracts.

 

Foreign Currency Balance.  At June 30, 2008, KCSM had financial assets and liabilities denominated in Mexican pesos of Ps.2,108 million and Ps.604 million, respectively. At December 31, 2007, KCSM had financial assets and liabilities denominated in Mexican pesos of Ps.1,921 million and Ps.595 million, respectively. At June 30, 2008 and December 31, 2007, the exchange rate was Ps.10.28 per U.S. dollar and Ps.10.90 per U.S. dollar, respectively.

 

 

Other comprehensive income refers to revenues, expenses, gains and losses that under U.S. GAAP are included in comprehensive income, a component of stockholders’ equity within the consolidated balance sheets, rather than net income. Under existing accounting standards, other comprehensive income for KCS reflects the net unrealized gain on cash flow hedge, net of tax, and amortization of prior service credit, net of tax.

 

KCS’ total comprehensive income is as follows (in millions):

 

 

 

KCSR 91/2% Senior Notes.  On May 8, 2008, pursuant to an offer to purchase, The Kansas City Southern Railway Company, a wholly-owned subsidiary of the Company (“KCSR”), commenced a cash tender offer and consent solicitation for any and all outstanding $200.0 million KCSR 91/2% Senior Notes due October 1, 2008 (the “91/2% Senior Notes”). KCSR received consents in connection with the tender offer and consent solicitation from holders of over 99% of the 91/2% Senior Notes and purchased the tendered notes in accordance with the terms of the tender offer with proceeds received from the issuance of new, $275.0 million 8.0% Senior Notes due June 1, 2015 (the “8.0% Senior Notes”).

 

KCSR 8.0% Senior Notes.  On May 30, 2008, KCSR, issued the $275.0 million 8.0% Senior Notes, which bear interest semiannually at a fixed annual rate of 8.0% and are fully and unconditionally guaranteed by KCS and certain subsidiaries of KCS who guarantee KCSR’s credit facilities (the “Note Guarantors”). The 8.0% Senior Notes and the note guarantees rank pari passu in right of payment with KCSR’s, KCS’, and the

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

Note Guarantors’ existing and future unsecured, unsubordinated obligations. A portion of the proceeds from the issuance of the 8.0% Senior Notes was used to pay $198.7 million of the principal amount of the 91/2% Senior Notes and the applicable premium and expenses associated with the redemption. The remaining proceeds from the issuance were used to reduce borrowings under the KCSR revolving credit facility and for general corporate purposes. The 8.0% Senior Notes are redeemable in whole or in part prior to June 1, 2012 by paying the greater of either 101% of the principal amount or a “make whole” premium.

 

 

On June 12, 2008, the Company called for redemption all of the outstanding shares of its 4.25% Series C Redeemable Cumulative Convertible Perpetual Preferred Stock (the “Series C Preferred Stock”) with a redemption date of July 15, 2008 (the “Redemption Date”). The holders of the outstanding shares had the option to redeem at a redemption price of $500 per share or convert each share into 33.4728 shares of KCS common stock. Each share converted would also be entitled to receive an appropriate number of common stock or other preferred stock purchase rights under KCS’ 2005 Rights Agreement. As of June 30, 2008, holders had converted 180,762 shares of Series C Preferred Stock into 6,050,604 shares of common stock. As of the Redemption Date, holders converted the remaining 219,238 shares of preferred stock into 7,338,505 shares of common stock.

 

 

Litigation.  The Company is a party to various legal proceedings and administrative actions, all of which, except as set forth below, are of an ordinary, routine nature and incidental to its operations. Included in these proceedings are various tort claims brought by current and former employees for job related injuries and by third parties for injuries related to railroad operations. KCS aggressively defends these matters and has established liability reserves, which management believes are adequate to cover expected costs. Although it is not possible to predict the outcome of any legal proceeding, in the opinion of management, other than those proceedings described in detail below, such proceedings and actions should not, individually, or in the aggregate, have a material adverse effect on the Company’s financial condition and liquidity. However, a material adverse outcome in one or more of these proceedings could have a material adverse impact on the operating results of a particular quarter or fiscal year.

 

Environmental Liabilities.  The Company’s U.S. operations are subject to extensive federal, state and local environmental laws and regulations. The major U.S. environmental laws to which the Company is subject include, among others, the Federal Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA,” also known as the Superfund law), the Toxic Substances Control Act, the Federal Water Pollution Control Act, and the Hazardous Materials Transportation Act. CERCLA can impose joint and several liabilities for cleanup and investigation costs, without regard to fault or legality of the original conduct, on current and predecessor owners and operators of a site, as well as those who generate, or arrange for the disposal of, hazardous substances. The Company does not believe that compliance with the requirements imposed by the environmental legislation will impair its competitive capability or result in any material additional capital expenditures, operating or maintenance costs. The Company is, however, subject to environmental remediation costs as described below.

 

The Company’s Mexico operations are subject to Mexican federal and state laws and regulations relating to the protection of the environment through the establishment of standards for water discharge, water supply, emissions, noise pollution, hazardous substances and transportation and handling of hazardous and solid waste. The Mexican government may bring administrative and criminal proceedings and impose economic sanctions against companies that violate environmental laws, and temporarily or even permanently close non-complying facilities.

 

The risk of incurring environmental liability is inherent in the railroad industry. As part of serving the petroleum and chemicals industry, the Company transports hazardous materials and has a professional team

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

available to respond to and handle environmental issues that might occur in the transport of such materials. Additionally, the Company is a partner in the Responsible Care^® program and, as a result, has initiated additional environmental, health and safety programs. The Company performs ongoing reviews and evaluations of the various environmental programs and issues within the Company’s operations, and, as necessary, takes actions intended to limit the Company’s exposure to potential liability.

 

The Company owns property that is, or has been, used for industrial purposes. Use of these properties may subject the Company to potentially material liabilities relating to the investigation and cleanup of contaminants, claims alleging personal injury, or property damage as the result of exposures to, or release of, hazardous substances. Although the Company is responsible for investigating and remediating contamination at several locations, based on currently available information, the Company does not expect any related liabilities, individually or collectively, to have a material impact on its financial position or cash flows. Should the Company become subject to more stringent cleanup requirements at these sites, discover additional contamination, or become subject to related personal or property damage claims, the Company could incur material costs in connection with these sites.

 

The Company records liabilities for remediation and restoration costs related to past activities when the Company’s obligation is probable and the costs can be reasonably estimated. Costs of ongoing compliance activities to current operations are expensed as incurred. The Company’s recorded liabilities for these issues represent its best estimates (on an undiscounted basis) of remediation and restoration costs that may be required to comply with present laws and regulations. Although these costs cannot be predicted with certainty, management believes that the ultimate outcome of identified matters will not have a material adverse effect on the Company’s consolidated financial position or cash flows.

 

Environmental remediation expense was $2.6 million and $3.2 million for the six months ended June 30, 2008 and 2007, respectively, and was included in casualties and insurance expense on the consolidated statements of income. Additionally, as of June 30, 2008, KCS had a liability for environmental remediation of $7.5 million. This amount was derived from a range of reasonable estimates based upon the studies and site surveys described above and in accordance with the Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”).

 

Casualty Claim Reserves.  The Company’s casualty and liability reserve is based on actuarial studies performed on an undiscounted basis. This reserve is based on personal injury claims filed and an estimate of claims incurred but not yet reported. While the ultimate amount of claims incurred is dependent on various factors, it is management’s opinion that the recorded liability is a reasonable estimate of aggregate future payments. Adjustments to the liability are reflected as operating expenses in the period in which changes to estimates are known. Casualty claims in excess of self-insurance levels are insured up to certain coverage amounts, depending on the type of claim and year of occurrence. The activity in the reserve follows (in millions):

 

 

The casualty claim reserve balance as of June 30, 2008 is based on an updated study of casualty reserves for data through May 31, 2008 and review of the last month’s experience. The activity for the six months ended June 30, 2008 primarily relates to the net settlements and the reserves for Federal Employers Liability Act (FELA), third-party, and occupational illness claims. The changes to the reserve in the current year

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

compared to the prior year primarily reflect a large litigation settlement in 2007 and the current accruals related to the trend of loss experience since the date of the prior study.

 

Reflecting potential uncertainty surrounding the outcome of casualty claims, it is reasonably possible based on assessments that future costs to settle casualty claims may range from approximately $87 million to $102 million. While the final outcome of these claims cannot be predicted with certainty, management believes that the $93.1 million recorded is the best estimate of the Company’s future obligations for the settlement of casualty claims at June 30, 2008. The most sensitive assumptions for personal injury accruals are the expected average cost per claim and the projected frequency rates for the number of claims that will ultimately result in payment. A 5% increase or decrease in either the expected average cost per claim or the frequency rate for claims with payments would result in an approximate $4.7 million increase or decrease in the Company’s recorded personal injury reserves.

 

Management believes that previous reserve estimates for prior claims were reasonable based on current information available. The Company is continuing its practice of accruing monthly for estimated claim costs, including any changes recommended by studies performed and evaluation of recent known trends; based on this practice, management believes all accruals are appropriately reflected.

 

Antitrust Lawsuit.  As of June 30, 2008, 29 putative class actions were on file against KCSR, along with the other Class I U.S. railroads (and, in some cases, the Association of American Railroads), in various Federal district courts alleging that the railroads conspired to fix fuel surcharges in violation of U.S. antitrust laws. On November 6, 2007, the Judicial Panel on Multidistrict Litigation ordered that these putative class action cases be consolidated for pretrial handling before the United States District Court for the District of Columbia, where the matters remain pending (“the Multidistrict Litigation”). All of the plaintiffs in the Multidistrict Litigation filed a Consolidated Amended Complaint on April 15, 2008. KCSR was not named as a defendant in that Consolidated Amended Complaint pursuant to an agreement with the Multidistrict Litigation plaintiffs to toll the statute of limitations, and the Multidistrict Litigation will not proceed with KCSR as a party. In any event, KCSR maintains there is no merit to the price fixing allegations asserted against the Company. If KCSR is named as a defendant in lawsuits making such claims in the future, either in the Multidistrict Litigation or otherwise, the Company intends to vigorously contest such allegations.

 

The New Jersey Attorney General’s office, which had sought information regarding fuel surcharges from KCSR and other railroads, has informed KCSR that it is discontinuing its investigation of KCSR with respect to fuel surcharges.

 

On March 25, 2008, Archer-Daniels-Midland Company (“ADM”) filed a complaint in the United States District Court for the District of Minnesota against the large Class I U.S. Railroads and KCSR, alleging that the railroads conspired to fix fuel surcharges in violation of U.S. antitrust laws and Minnesota antitrust statutes, or that fuel surcharges constituted unreasonable practices in violation of federal statutes. On July 25, 2008, KCSR received notification that the action has been dismissed.

 

Disputes Relating to Payments for the Use of Trackage and Haulage Rights and Interline Services.  KCSM and Ferrocarril Mexicano, S.A. de C.V. (“Ferromex”) both initiated administrative proceedings seeking a determination by the Mexican Secretaría de Comunicaciones y Transportes (“Ministry of Communications and Transportation” or “SCT”) of the rates that the companies should pay each other in connection with the use of trackage and haulage rights and interline and terminal services. The SCT, in March of 2002, issued rulings setting the rates for trackage rights. In August of 2002, the SCT issued a ruling setting the rates for interline and terminal services. KCSM and Ferromex appealed both rulings.

 

Following the trial and appellate court decisions, the Mexican Supreme Court in February of 2006, in a ruling from the bench, sustained KCSM’s appeal of the SCT’s trackage rights ruling, vacating the ruling and ordering the SCT to issue a new ruling consistent with the Court’s decision. On June 27, 2008, KCSM was served with the new ruling issued by the SCT. In this ruling, the SCT establishes the consideration that KCSM

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

and Ferromex must pay each other in connection with trackage rights granted between 2002 and 2004, and further states that should KCSM and Ferromex fail to reach an agreement in connection with the rates for the years after 2004, the SCT shall make a determination along the same lines. KCSM is currently in the process of analyzing the contents of this new ruling and evaluating its alternatives in connection therewith, including the possibility of challenging the ruling.

 

Related to the interline and terminal services appeal, as of the date of this filing, KCSM has not yet received the written opinion of the Mexican Supreme Court.

 

In addition, Ferromex filed two different commercial proceedings against KCSM in 2001 and 2004. In the first claim, which was served in 2001 and is related to the payment of consideration for interline services, KCSM received a favorable decision and Ferromex was ordered to pay costs and expenses. This decision is pending on an appeal filed by Ferromex. With respect to the second claim filed by Ferromex in 2004, KCSM received an unsatisfactory decision; however, the judgment is subject to an appeal which has been filed by KCSM.

 

Regarding the above matters, KCSM expects various proceedings and appeals to continue to evolve over the next few years. Additionally, KCSM believes that, based on its assessments of the facts in the cases as well as reviews of its defenses, the financial statements reflect management’s best estimates for outcomes in these matters, and although there is uncertainty, management does not believe there will be any material differences to the future results of operations in any quarter period related to these matters.

 

Disputes Relating to the Scope of the Mandatory Trackage Rights.  KCSM and Ferromex are parties to various civil cases involving disputes over the application and proper interpretation of the mandatory trackage rights. In August 2002, the SCT issued rulings determining Ferromex’s trackage rights in Monterrey, Nuevo León. KCSM and Ferromex both appealed the SCT’s rulings. At the Mexican Administrate Federal Court level, KCSM obtained what it believed were favorable rulings in April 2005. Ferromex appealed these rulings and the case was returned to the Mexican Administrative Federal Court. The Administrative Federal Court issued a ruling on June 11, 2007, which was served on KCSM on August 8, 2007. In the ruling, the Mexican Administrative Federal Court reversed the earlier favorable ruling and decided that Ferromex could use certain auxiliary tracks awarded to KCSM in its concession. KCSM appealed this ruling at the beginning of September 2007, arguing that the Mexican Administrative Federal Court wrongly failed to consider the earlier favorable decision in making its revised ruling and also failed to consider the length and limits of the trackage rights included in KCSM’s Concession title. On April 30, 2008, the Collegiate Court granted the appeal to KCSM in order for the Higher Court to issue a new judgment based upon the Concession title. The Company believes that based on its assessment of the facts in this case, there will be no material effect on KCS’ results of operations.

 

SCT Sanction Proceedings.  In April 2006, the SCT initiated a proceeding against KCSM, claiming that KCSM had failed to make certain minimum capital investments projected for 2004 and 2005 under its five-year business plan filed with the SCT prior to its acquisition by Kansas City Southern. KCSM believes it made capital expenditures exceeding the required amounts. KCSM responded to the SCT by providing evidence in support of its investments and explaining why it believes sanctions are not appropriate. In May 2007, KCSM was served with an SCT resolution regarding the sanction proceeding for 2004. In June 2007, KCSM was served with an SCT notification that it failed to make minimum capital investments for 2004 and 2005. The SCT imposed a fine in the amount of Ps.46,800. On August 16, 2007, KCSM filed a nullity claim against the 2004 investment plan resolution issued by the SCT, and on August 20, 2007, KCSM filed a nullity claim against the 2005 investment plan resolution, both before the Mexican Administrative Federal Court and if necessary, KCSM will have the right to appeal any adverse ruling by the Mexican Administrative Federal Court before the Mexican Federal Magistrates Tribunal. KCSM believes that even if the threatened sanctions become effective, there will be no material effect on KCSM’s results of operations. However, if these proceedings are conclusively ruled adversely against KCSM and sanctions are imposed, KCSM could be

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

subject to possible future revocation of its Concession if the SCT imposes sanctions on three additional occasions for the same failure over the remaining term of the Concession.

 

On July 23, 2008, the SCT delivered to KCSM notice of new sanction proceedings against KCSM, claiming, among other things, that KCSM refused to grant to Ferromex access to certain trackage rights at the same location on six different occasions. If it were decided that each of these refusals warranted a separate sanction and if final decisions were entered against KCSM in each of these instances, KCSM could be subject to a future SCT action seeking revocation of its Concession. The Company believes it has strong defenses to all charges, that there is no basis for sanctions, including the same or similar sanctions multiple times, and KCSM intends to defend all these proceedings vigorously. At the date of this filing management believes that based on its assessment of the facts, even if ultimately an unsatisfactory ruling was handed down from the SCT, it would not have a material financial effect on KCSM’s results of operations.

 

Credit Risk.  An area of risk currently being monitored by KCSM is the recent downturn in the automotive industry and related customer concentrations. Significant changes in customer concentration or payment terms, deterioration of customer credit-worthiness or weakening in economic trends could have a significant impact on the collectability of KCSM’s receivables and operating results. If the financial condition of KCSM’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Currently, management’s assessment is that it will collect all outstanding receivables or based on its assessment at this time has recorded necessary reserves as appropriate.

 

 

The liability for unrecognized tax benefits decreased from $32.6 million as of December 31, 2007 to $1.3 million as of June 30, 2008, due to an Internal Revenue Service (“IRS”) examination for years 1997 through 2002. The remaining $1.3 million liability for unrecognized tax benefits at June 30, 2008 would affect the effective income tax rate if recognized and is not expected to change in the next 12 months.

 

As a result of the IRS examination settlement, accrued interest and penalties on unrecognized tax benefits was reduced from $15.8 million to zero as of December 31, 2007 and June 30, 2008, respectively, of which $6.6 million was recorded as a reduction in interest expense in the second quarter of 2008. The Company did not accrue for interest as of June 30, 2008, as an adjustment of the unrecognized tax benefit would affect the net operating losses available to reduce future tax payments.

 

 

The Company strategically manages its rail operations as one reportable business segment over a single coordinated rail network that extends from the Midwest and southeast portions of the United States south into Mexico and connects with other Class I railroads. Financial information reported at this level, such as revenues, operating income and cash flows from operations, is used by corporate management, including the Company’s chief operating decision-maker, in evaluating overall financial and operational performance, market strategies, as well as the decisions to allocate capital resources.

 

The Company’s strategic initiatives, which drive its operational direction, are developed and managed at the Company’s headquarters and targets are communicated to its various regional activity centers. Corporate management is responsible for, among others, KCS’ marketing strategy, the oversight of large cross-border customer accounts, overall planning and control of infrastructure and rolling stock, the allocation of capital resources based upon growth and capacity constraints over the coordinated network, and other functions such as financial planning, accounting, and treasury.

 

The role of each region is to manage the operational activities and monitor and control costs over the coordinated rail network. Such cost control is required to ensure that pre-established efficiency standards set at

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

the corporate level are attained. The regional activity centers are responsible for executing the overall corporate strategy and operating plan established by corporate management as a coordinated system.

 

The following tables (in millions) provide information by geographic area pursuant to Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information” (“SFAS 131”) as follows:

 

 

 

 

KCSR has outstanding $200.0 million of 71/2% Senior Notes due 2009 and $275.0 million of 8.0% Senior Notes due 2015 which are unsecured obligations of KCSR, which are also jointly and severally and fully and unconditionally guaranteed on an unsecured senior basis by KCS and certain wholly-owned domestic subsidiaries. As a result, the following accompanying condensed consolidating financial information (in millions) has been prepared and presented pursuant to SEC Regulation S-X Rule 3-10 “Financial statements of guarantors and issuers of guaranteed securities registered or being registered.” This condensed information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with U.S. GAAP. For the 71/2% senior note issue, KCSR registered exchange notes with the SEC that have substantially identical terms and associated guarantees; and all of the initial 71/2% senior notes have been exchanged for $200.0 million of registered exchange notes. The 8.0% senior notes were registered by means of an amendment to KCS’ shelf registration statement filed and declared effective by the SEC on May 23, 2008.

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

CONDENSED CONSOLIDATING STATEMENTS OF INCOME

 

 

CONDENSED CONSOLIDATING STATEMENTS OF INCOME — (Continued)

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

 

CONDENSED CONSOLIDATING BALANCE SHEETS