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, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

 

Large accelerated filer þ           Accelerated filer o           Non-accelerated filer o

 

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
September 30, 2007

 

Index

 

Kansas City Southern

 

Form 10-Q
September 30, 2007

 

PART I — FINANCIAL INFORMATION

 

 

Introductory Comments.

 

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”). For the purposes of this report, unless the context otherwise requires, all references herein to “KCS” and the “Company” shall mean Kansas City Southern and its subsidiaries. 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, 2006, and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-Q. Results for the three and nine months ended September 30, 2007, are not necessarily indicative of the results expected for the full year ending December 31, 2007.

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 September 30, 2007, and December 31, 2006, the results of operations for the three and nine months ended September 30, 2007 and 2006, and cash flows for the nine months ended September 30, 2007 and 2006. 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, 2006. The results of operations for the three and nine months ended September 30, 2007, are not necessarily indicative of the results to be expected for the full year ending December 31, 2007. Certain prior year amounts have been reclassified to conform to the current year presentation.

 

 

Effective January 2006, Statement of Financial Accounting Standards No. 123R (Revised) “Share-Based Payments” (“SFAS 123R”) was adopted on a modified prospective basis requiring the Company to measure the cost of equity classified share-based compensation awards at grant date fair value in exchange for employee services rendered. All stock options and nonvested stock awards are granted at their market value on the date of grant. Their fair value is determined on the date of grant and recorded as compensation expense over the attribution period, which is generally the vesting period. Stock options and the Employee Stock Purchase Plan (“ESPP”) awards are valued at their fair value as determined using the Black-Scholes pricing model.

 

Stock Option Plan.  The Kansas City Southern 1991 Amended and Restated Stock Option and Performance Award Plan (as amended and restated effective August 7, 2007) (the “Plan”) provides for the granting of options to purchase up to 16.0 million shares of the Company’s common stock by officers and other designated employees. Options have been granted under the Plan at 100% of the average market price of the Company’s stock on the date of grant and generally have a five year cliff vesting period and are exercisable over the ten year contractual term, except that options outstanding with limited rights (“LRs”) or limited stock appreciation rights (“LSARs”) become immediately exercisable upon certain defined circumstances constituting a change in control of the Company. The Plan includes provisions for stock appreciation rights, LRs and LSARs. All outstanding options include LSARs, except for options granted to non-employee Directors prior to 1999. The grant date fair value, less estimated forfeitures, is recorded to expense on a straight-line basis over the vesting period.

 

The fair value of each stock option award is estimated on the date of grant using the Black-Scholes option pricing model. The weighted-average assumptions used to value options issued during the respective periods are as follows:

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

The Company has not paid dividends to common stockholders since January of 2000 and currently does not expect to pay dividends to common stockholders in the future. The expected volatility is based on the historical volatility of the Company’s stock price over a term equal to the estimated life of the options. The risk-free interest rate is determined based on the U.S. Treasury rates approximating the expected life of the options granted, which represents the period of time the awards are expected to be outstanding and is based on the historical experience of similar awards.

 

The following table summarizes activity under the stock option plan:

 

 

Compensation expense of $0.2 million and $0.3 million was recognized for stock option awards for the three months ended September 30, 2007 and 2006, and $0.5 million and $1.0 million for the nine months ended September 30, 2007 and 2006, respectively. The total income tax benefit recognized in the income statement for stock options was $0.1 million for the three months ended September 30, 2007 and 2006, respectively, and $0.2 million and $0.4 million for the nine months ended September 30, 2007 and 2006, respectively.

 

Additional information regarding stock option exercises appears in the table below (in millions):

 

 

As of September 30, 2007, $1.2 million of unrecognized compensation cost relating to nonvested stock options is expected to be recognized over a weighted-average period of 1.65 years. At September 30, 2007, there were 1,871,521 shares available for future grants under the Plan.

 

Nonvested Stock.  The 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 a five year cliff vesting for employees and one year for 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.

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

A summary of nonvested stock activity is as follows:

 

 

Compensation cost on nonvested stock was $1.4 million and $0.4 million for the three months ended September 30, 2007 and 2006, and $4.7 million and $2.1 million for the nine months ended September 30, 2007 and 2006, respectively. The total income tax benefit recognized in the income statement for nonvested stock awards was $0.5 million and $0.1 million for the three months ended September 30, 2007 and 2006, and $1.7 million and $0.7 million for the nine months ended September 30, 2007 and 2006, respectively.

 

As of September 30, 2007, $18.4 million of unrecognized compensation costs related to nonvested stock is expected to be recognized over a weighted-average period of 1.66 years. The fair value (at vest date) of shares vested during the nine months ended September 30, 2007, was $1.7 million.

 

Performance Based Awards.  During 2007, the Company granted performance based nonvested stock awards which are subject to continued employment through January 2010. 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. Over the three year performance period, participants in the aggregate can earn up to a maximum of 864,724 shares which have a weighted-average grant date fair value of $29.98 per share.

 

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 expense on performance based awards was $0.7 million and $2.0 million for the three and nine months ended September 30, 2007, respectively. Total income tax benefit recognized in the income statement for performance based awards was $0.2 million and $0.7 million for the three and nine months ended September 30, 2007.

 

As of September 30, 2007, $2.9 million of unrecognized compensation cost related to performance based awards is expected to be recognized over a weighted-average period of 1.12 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.

 

 

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

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

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):

 

 

Potentially dilutive shares excluded from the calculation:

 

 

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):

 

 

 

The Company does not engage in the trading of derivative financial instruments except where the Company’s objective is to manage fuel price risk and foreign currency fluctuations. 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.

 

Fuel Derivative Transactions.  As of September 30, 2007, the Company did not have any outstanding fuel swap agreements. Fuel hedging transactions, consisting of fuel swaps, resulted in a decrease in fuel expense of $0.3 million and $0.6 million for the nine months ended September 30, 2007 and 2006, respectively.

 

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

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

conditions. As of September 30, 2007, KCSM did not have any outstanding call option contracts. As of September 30, 2006, KCSM had one Mexican peso call option outstanding in the notional amount of $1.7 million, based on the average exchange rate of Ps.14.50 Mexican pesos per U.S. dollar. This option expired on May 29, 2007.

 

As of September 30, 2007, the Company had six U.S. dollar forward contracts with an aggregate notional amount of $0.6 million. The U.S. dollar contracts mature between June and December 2008 and are based on the forward exchange rate ranging from Ps.11.35 to Ps.11.49.

 

Foreign Currency Balance.  At September 30, 2007 and at December 31, 2006, KCSM had financial assets and liabilities denominated in Mexican pesos of Ps.2,119.4 million and Ps.2,304.0 million, and Ps.695.6 million and Ps.651.4 million, respectively. At September 30, 2007 and at December 31, 2006, the exchange rate was Ps.10.92 and Ps.10.82, 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 amortization of interest rate swaps and amortization of prior service credit.

 

KCS’ total comprehensive income was as follows:

 

 

 

During the third quarter, the Company reclassified the obligations outstanding under its Amended and Restated Credit Agreement dated April 28, 2006, as amended on May 31, 2007 (the “Credit Agreement”), from long term debt to current debt. The revolving credit facility, the swing line facility and the letter of credit facility have a final termination date of April 28, 2011 and the term loan B facility and the term loan C facility have a final termination date of April 28, 2013. However, the Credit Agreement provides for an earlier termination date that is 90 days prior to the earliest final maturity date of any outstanding 2000 Senior Notes and 2002 Senior Notes unless the facilities are rated at least Ba3 by Moody’s Investor Service (“Moody’s”) and BB+ by Standards & Poor’s Rating Services (“S&P”) (in each case, with at least stable outlooks) or prior to such date the 2000 Senior Notes and 2002 Senior Notes have been refinanced in full or an amount sufficient to indefeasibly repay such 2000 Senior Notes and 2002 Senior Notes has been deposited with the applicable bond trustee. The earliest final maturity date of the 2000 Senior Notes and 2002 Senior Notes is currently October 1, 2008. On May 14, 2007, Moody’s assigned the debt a rating of Ba2 and on September 25, 2007, S&P rated the debt BB. Based upon the aforementioned termination provision, the rating criteria of S&P was not met resulting in a maturity date of July 3, 2008. The Company intends to refinance the 2000 Senior Notes prior to such date. As of September 30, 2007, the obligations reclassified from long term debt to current debt totaled $347.8 million.

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

 

Litigation.  The Company is a party to various legal proceedings and administrative actions, all of which 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 the Company’s management, other than those proceedings described in detail below, such proceedings and actions should not, individually or in the aggregate, have a material effect on the Company’s financial position. However, a material adverse outcome in one or more of these proceedings could have a material impact on the operating results of a particular period.

 

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 Mexican 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 available to respond 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 certain 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 results of operations, 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 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

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

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 results of operations, financial position or cash flows.

 

Environmental remediation expense was $5.3 million and $3.3 million for the nine months ended September 30, 2007 and 2006, respectively, and was included in casualties and insurance expense on the consolidated statements of income. Additionally, as of September 30, 2007, KCS had a liability for environmental remediation of $9.7 million. This amount was derived from a range of reasonable estimates based upon the studies and site surveys described above and in accordance with Statement of Financial Accounting Standards No. 5 “Accounting for Contingencies” (“SFAS 5”).

 

Casualty Claim Reserves.  The Company’s casualty and liability reserve for its U.S. business segment is based on actuarial studies performed on an undiscounted basis. The reserve is based on 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 the adjustments 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. Activity in the reserve follows (in millions):

 

 

The casualty claim reserve balance as of September 30, 2007 is based on an updated study of casualty reserves for data through May 31, 2007 and a review of the last four month’s experience. The activity for the nine months ended September 30, 2007 primarily relates to the net settlements and payments related to a large casualty claim, and the reserves for Federal Employers Liability Act (FELA), third-party, and occupational illness claims. The changes to the reserve in the current year compared to the prior year primarily reflect a large litigation settlement and the current accruals related to the trend of loss experience since the date of the prior study.

 

Reflecting the uncertainty surrounding the outcome of casualty claims, it is reasonably possible that costs to settle casualty claims may range from approximately $83 million to $97 million. However, management believes that the $87.1 million recorded is the best estimate of the Company’s future obligations for the settlement of casualty claims at September 30, 2007. 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 $4.4 million increase or decrease in the Company’s recorded personal injury reserves.

 

Antitrust Lawsuit.  As of September 30, 2007, 24 putative class actions have been filed against The Kansas City Southern Railway Company, a wholly-owned subsidiary of the Company (“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. A motion is presently pending before the Judicial Panel on Multidistrict Litigation (“JPML”) to transfer all of these lawsuits to a single district court for coordinated pretrial proceedings. Because plaintiffs and defendants

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

agree that multidistrict treatment of the lawsuits is appropriate, KCSR anticipates that the JPML motion will be granted. However, because the JPML has not yet ruled, the transferee court has not yet been identified. In addition, the New Jersey Attorney General has initiated an investigation of rail fuel surcharges and has sought information regarding those surcharges from KCSR and other railroads. KCSR is cooperating with the New Jersey Attorney General’s request for information while preserving all of its legal defenses. KCSR believes that the price fixing allegations against it have no merit, believes it has strong defenses and intends to vigorously contest these lawsuits through trial and appeal if necessary. While the final outcome of these matters cannot be predicted with certainty, the Company believes that these matters will not have a material adverse effect on any of its consolidated financial position, results of operations, cash flows or business.

 

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 Secretaria 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 and haulage 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 and haulage rights ruling, vacating the ruling and ordering the SCT to issue a new ruling consistent with the Court’s opinion. KCSM has not yet received the written opinion of the Mexican Supreme Court relating to the interline and terminal services appeal. In October 2006, KCSM was served with a claim raised by Ferromex in which Ferromex asked for information concerning the interline traffic between KCSM and Ferromex from January 2002 through December 2004. KCSM filed an answer to this claim and expects this litigation to continue over the next few years. 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.

 

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 this trackage rights included in KCSM’s 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.

 

Claims Asserted under the TMM Acquisition Agreement.  On September 24, 2007, KCS entered into a Settlement Agreement (“Agreement”) with Grupo TMM, S.A.B. (“TMM”, formerly Grupo TMM, S.A.), TMM Logistics, S.A. de C.V., a subsidiary of TMM, and Vex Asesores Corporativos, S.A. de C.V. (formerly Jose F. Serrano International Business, S.A. de C.V.) (the “Consulting Firm”), resolving certain claims and disputes over liabilities established as part of KCS’ acquisition of KCSM (successor by merger to Grupo KCSM). Pursuant to the terms of the Agreement, KCS agreed to pay TMM $54.1 million in cash to retire two notes totaling $86.6 million created at the closing of the KCSM acquisition to cover certain post-closing contingencies and tax liabilities. This agreement was primarily accounted for as a change to the final purchase price of KCS’ investment in KCSM. KCSM adjusted its purchase accounting assets and will reduce prospectively the amortization of these assets over approximately the next twenty four years. In addition, the parties also agreed to terminate the consulting agreement between KCS and the Consulting Firm and make the final annual

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

payment of $3.0 million due December 15, 2007, payable on settlement. The settlement amount of $57.1 million was paid by KCS to TMM on October 1, 2007.

 

Acquisition of Locomotives.  In August 2006, KCSR entered into an agreement with Electro-Motive Diesel, Inc. (“EMD”) to acquire 30 new locomotives at a cost of $62.1 million. Of the 30 locomotives, 20 have been delivered and financed through an operating lease as of September 30, 2007 with the remainder to be delivered in October and November of 2007. The company intends to finance the remaining 10 locomotives through an operating lease.

 

In April 2007, KCSR and KCSM entered into a definitive purchase agreement with EMD to acquire 70 locomotives for delivery in October 2007 through April 2008 at an aggregate cost of approximately $144.9 million. KCSR will acquire 30 of these locomotives and KCSM will acquire the other 40. The Company intends to finance the acquisitions through operating leases.

 

In August 2007, KCSR and KCSM entered into a definitive purchase agreement with General Electric Company (“GE”) to acquire 80 locomotives with delivery beginning in September of 2007 continuing through August 2008 at an aggregate cost of approximately $174 million, with 30 delivered to KCSR and the remaining 50 delivered to KCSM. In September of 2007, KCSR received all 30 locomotives and has financed them through an operating lease. KCSM received nine locomotives in September, which have been recorded as assets held for sale. KCSM intends to finance the acquisitions with operating leases.

 

Panama Canal Railway Company.  Under the terms of a loan agreement with the International Finance Corporation (“IFC”), the Company is a guarantor for up to $3.9 million of the IFC debt of Panama Canal Railway Company (“PCRC”). Also, if PCRC terminates its concession contract with the Panamanian government without the IFC’s consent, KCS is a guarantor for up to $9.5 million of the outstanding senior loans. The Company is also a guarantor for up to $0.3 million of PCRC equipment loans and capital leases, and has issued three irrevocable letters of credit totaling approximately $2.8 million to fulfill the Company’s fifty percent guarantee of equipment loans.

 

 

In June 2006, the Financial Accounting Standards Board issued Interpretation Number 48 “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109, Accounting for Income Taxes” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 requires the Company to recognize in the financial statements the benefit of a tax position only if the impact is more likely than not of being sustained on audit based on the technical merits of the position. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods and disclosure.

 

The provisions of FIN 48 were effective for KCS beginning January 1, 2007. The Company recognized a cumulative effect of the change in accounting principle of $1.3 million recorded as a decrease to opening retained earnings. The total unrecognized tax benefit as of January 1, 2007 was $26.3 million of which $5.1 million would impact the effective tax rate if recognized.

 

The Company recorded a $3.9 million increase in unrecognized tax benefits in the second quarter due to uncertainty regarding the timing of deducting certain reserves. The increase to unrecognized tax benefits would have no impact on the effective tax rate if recognized.

 

Within the next twelve months the company anticipates a tax examination will be settled which will result in a decrease in unrecognized tax benefits of approximately $12 million. The tax examination settlement is expected to have an immaterial affect on the effective tax rate.

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

Tax returns filed in the United States from 1997 through the current year remain open to examination by the Internal Revenue Service. Tax returns filed in Mexico from 2001 through the current year remain open to examination by the taxing authorities in Mexico.

 

Interest and penalties related to uncertain tax positions are included in income before taxes on the income statement. Accrued interest and penalties as of the date of adoption was $13.5 million with an increase of $2.7 million in 2007.

 

On October 1, 2007 the Entrepreneurial Tax of Unique Rate (referred to by its Spanish acronym, IETU or “Flat Tax”) in Mexico was published. The Flat Tax law will be effective on January 1, 2008 and replaces the Asset Tax law. The Flat Tax applies to a different tax base than the income tax and will be paid if the Flat Tax exceeds the income tax computed under existing law. Additional secondary laws and clarifying rulings will be published before the effective date of the Flat Tax. The Company is assessing various tax alternatives and is awaiting additional rulings expected to be issued in the fourth quarter. The Company is currently unable to determine with certainty the full impact of the new tax law and whether it will have a material effect on the consolidated financial statements.

 

 

The accompanying segment reporting information (in millions) has been prepared and presented pursuant to Statement of Financial Accounting Standards No. 131, “Disclosures about Segments of an Enterprise and Related Information.” Operating units are defined as either U.S. or Mexico segments. Appropriate eliminations of revenue and reclassifications of operating revenues and expenses have been recorded in deriving consolidated data. The U.S. segment consists primarily of KCSR and The Texas Mexican Railway Company (“Tex-Mex”). The Mexico segment consists of KCSM and Arrendadora KCSM, S.A. de C.V. (“Arrendadora”).

 

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

 

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

 

KCSR has outstanding $200.0 million of 91/2% Senior Notes due 2008 and $200.0 million of 71/2% Senior Notes due 2009. These notes are unsecured obligations of KCSR, however, they are also jointly and severally and fully and unconditionally guaranteed on an unsecured senior basis by KCS and certain wholly-owned domestic subsidiaries. For each of these note issues, KCSR registered exchange notes with the SEC that have substantially identical terms and associated guarantees and all of the initial senior notes for each issue have been exchanged for $200.0 million of registered exchange notes for each respective note issue.

 

The 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 affiliates whose securities collateralize an issue 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.

 

CONDENSED CONSOLIDATING STATEMENTS OF INCOME

 

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)

 

 

 

 

Kansas City Southern

 

Notes to Consolidated Financial Statements — (Continued)