UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
ý | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the fiscal year ended December 31, 2018
or
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number: 1-4717
KANSAS CITY SOUTHERN
(Exact name of registrant as specified in its charter)
Delaware (State or other jurisdiction of incorporation or organization) |  | 44-0663509 (I.R.S. Employer Identification No.) |
427 West 12th Street, Kansas City, Missouri | 64105 | |
(Address of principal executive offices) | (Zip Code) | |
816.983.1303
(Registrant’s telephone number, including area code)
None
(Former name, former address and former fiscal year, if changed since last report)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class | Name of Each Exchange on Which Registered | |
Preferred Stock, Par Value $25 Per Share, 4%, Noncumulative | New York Stock Exchange | |
Common Stock, $.01 Per Share Par Value | New York Stock Exchange | |
Securities registered pursuant to Section 12(g) of the Act:
None
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes ý No ¨
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act. Yes ¨ No ý
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 ý No ¨
Indicate by check mark whether the registrant has submitted electronically, every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes ý No ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
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):
Large accelerated filer ý | Accelerated filer o | Non-accelerated filer o | Smaller reporting company o | |
(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 ¨ No ý
The aggregate market value of common stock held by non-affiliates of the registrant was $10.77 billion at June 30, 2018. There were 100,941,555 shares of $.01 par common stock outstanding at January 18, 2019.
DOCUMENTS INCORPORATED BY REFERENCE
Kansas City Southern’s Definitive Proxy Statement for the 2019 Annual Meeting of Stockholders which will be filed no later than 120 days after December 31, 2018, is incorporated by reference in Part III.
KANSAS CITY SOUTHERN
2018 FORM 10-K ANNUAL REPORT
Table of Contents
Page | ||
PART I | ||
Item 1. | ||
Item 1A. | ||
Item 1B. | ||
Item 2. | ||
Item 3. | ||
Item 4. | ||
PART II | ||
Item 5. | ||
Item 6. | ||
Item 7. | ||
Item 7A. | ||
Item 8. | ||
Item 9. | ||
Item 9A. | ||
Item 9B. | ||
PART III | ||
Item 10. | ||
Item 11. | ||
Item 12. | ||
Item 13. | ||
Item 14. | ||
PART IV | ||
Item 15. | ||
Item 16. | ||
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Item 1. | Business |
COMPANY OVERVIEW
Kansas City Southern, a Delaware corporation, is a holding company with domestic and international rail operations in North America that are strategically focused on the growing north/south freight corridor connecting key commercial and industrial markets in the central United States with major industrial cities in Mexico. 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. KCS and its subsidiaries had approximately 7,200 employees on December 31, 2018.
KCS controls and owns all of the stock of The Kansas City Southern Railway Company (“KCSR”), a U.S. Class I railroad founded in 1887. KCSR serves a ten-state region in the midwest and southeast regions of the United States and has the shortest north/south rail route between Kansas City, Missouri and several key ports along the Gulf of Mexico in Alabama, Louisiana, Mississippi and Texas.
KCS controls and owns all of the stock of Kansas City Southern de México, S.A. de C.V. (“KCSM”). Through its 50-year concession from the Mexican government (the “Concession”), which could expire in 2047 unless extended, KCSM operates a key commercial corridor of the Mexican railroad system and has as its core route the most strategic portion of the shortest, most direct rail passageway between Mexico City and Laredo, Texas. Laredo is a principal international gateway through which a substantial portion of rail and truck traffic between the United States and Mexico crosses the border. KCSM serves most of Mexico’s principal industrial cities and three of its major seaports. KCSM’s rail lines provide exclusive rail access to the United States and Mexico border crossing at Nuevo Laredo, Tamaulipas. Under the Concession, KCSM has the right to use and operate the southern half of the rail bridge at Laredo, Texas, which spans the Rio Grande River between the United States and Mexico. The Company owns the northern half of this bridge through its ownership of Mexrail, Inc. (“Mexrail”).
KCSM also provides exclusive rail access to the port of Lazaro Cardenas on the Pacific Ocean. The Mexican government developed the port at Lazaro Cardenas principally to serve Mexican markets and as an alternative to the U.S. west coast ports for Asian and South American traffic bound for North America.
The Company wholly owns Mexrail which, in turn, wholly owns The Texas Mexican Railway Company (“Tex-Mex”). Tex-Mex owns a 157-mile rail line extending from Laredo, Texas to the port city of Corpus Christi, Texas, which connects the operations of KCSR with KCSM.
The KCS coordinated rail network (KCSR, KCSM and Tex-Mex) comprises approximately 6,700 route miles extending from the midwest and southeast portions of the United States south into Mexico and connects with all other Class I railroads, providing shippers with an effective alternative to other railroad routes and giving direct access to Mexico and the southeast and southwest United States through alternate interchange hubs.
Panama Canal Railway Company (“PCRC”), an unconsolidated joint venture company owned equally by KCS and Mi-Jack Products, Inc. (“Mi-Jack”), was awarded a concession from the Republic of Panama to reconstruct and operate the Panama Canal Railway, a 47-mile railroad located adjacent to the Panama Canal that provides international container shipping companies with a railway transportation alternative to the Panama Canal. The concession was awarded in 1998 for an initial term of 25 years with an automatic renewal for an additional 25-year term. The Panama Canal Railway is a north-south railroad traversing the isthmus of Panama between the Atlantic and Pacific oceans.
Other subsidiaries and affiliates of KCS include the following:
• | KCSM Servicios, S.A. de C.V. (“KCSM Servicios”), a wholly-owned and consolidated subsidiary that provides employee services to KCSM; |
• | Meridian Speedway, LLC (“MSLLC”), a seventy percent-owned consolidated affiliate that owns the former KCSR rail line between Meridian, Mississippi and Shreveport, Louisiana, which is the portion of the rail line between Dallas, Texas and Meridian known as the “Meridian Speedway.” Norfolk Southern Corporation, through its wholly-owned subsidiary, The Alabama Great Southern Railroad Company, owns the remaining thirty percent of MSLLC; |
• | TFCM, S. de R.L. de C.V. (“TCM”), a forty-five percent-owned unconsolidated affiliate that operates a bulk liquid terminal in San Luis Potosí, Mexico; |
• | Ferrocarril y Terminal del Valle de México, S.A. de C.V. (“FTVM”), a twenty-five percent-owned unconsolidated affiliate that provides railroad services as well as ancillary services in the greater Mexico City area; and |
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• | PTC-220, LLC (“PTC-220”), a fourteen percent-owned unconsolidated affiliate that holds the licenses to large blocks of radio spectrum and other assets for the deployment of Positive Train Control (“PTC”). See Government Regulation section for further information regarding PTC. |
MARKETS SERVED
2018 Revenues Business Mix | |
Chemical and petroleum. This commodity group includes products such as chemicals, plastics, petroleum, liquefied petroleum gas, and petroleum refined products, such as gasoline and diesel. KCS transports these products to markets in the midwest, southeast and northeast United States and throughout Mexico through interchanges with other rail carriers. The chemical and plastic products are used in the automotive, housing and packaging industries as well as in general manufacturing. KCS hauls petroleum products across its network and as U.S. petroleum refineries have continued to increase their refining capacity, they have coordinated with KCS to develop additional long-term storage opportunities which complement a fluid freight railroad operation. |  |
Industrial and consumer products. This commodity group includes forest products as well as metals and scrap. Forest products consist of shipments to and from paper and lumber mills in the southeast United States timber-producing region that KCS serves directly and indirectly through its various short-line connections. Metals and scrap consist of shipments of steel and metallic ores such as iron, zinc and copper. The majority of steel produced and metallic ores mined in Mexico are consumed within Mexico. Higher-end finished products such as steel coils are used by Mexican manufacturers in automobiles, household appliances, the oil and gas industry, and other consumer goods which are imported from the United States through land borders and through the seaports served by KCS’s rail network. KCS also transports steel coils, plates and pipe from U.S. and Mexican-based mini-mills to locations in the U.S. and Mexico for oil drilling, appliance and automotive applications. This commodity group also includes U.S. military transports, Mexico and U.S. domestic cement shipments and appliances manufactured in Mexico that are imported into the United States.
Agriculture and minerals. The agriculture and minerals commodity group consists primarily of grain and food products. Shipper demand for agriculture products is affected by competition among sources of grain and grain products, as well as price fluctuations in international markets for key commodities. In the United States, KCS’s rail lines receive and originate shipments of grain and grain products for delivery to feed mills, food and industrial consumers in the U.S. and Mexico. United States export grain shipments and Mexico import grain shipments include primarily corn, wheat, and soybeans. Food products consist mainly of soybean meal, grain meal, oils, canned goods, distillers dried grains, corn syrup and sugar. Other shipments consist of a variety of products including ores, minerals, clay and glass used across North America.
Energy. The energy commodity group includes coal, frac sand, petroleum coke and crude oil. KCS hauls unit trains (trains transporting a single commodity from one source to one destination) of coal for electric generating plants in the central United States. The coal originates from the Powder River Basin in Wyoming and is interchanged to KCS at Kansas City, Missouri. Coal mined in the midwest United States is transported in non-unit trains to industrial consumers such as paper mills, steel mills, and cement companies. Frac sand originating primarily in Wisconsin, Illinois or Iowa is delivered to transloads located in northeast Texas, northern Louisiana and south Texas for distribution to gas and oil wells in the region. KCS transports petroleum coke from refineries in the United States to various industries in the U.S. and Mexico including export through the Pabtex terminal located in Port Arthur, TX. The majority of crude by rail business originates in Canada, with spot shipments coming from west Texas, and is delivered to U.S. Gulf Coast refineries and tank farms in Texas, Louisiana, and Alabama.
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Intermodal. The intermodal freight sector consists primarily of hauling freight containers or truck trailers on behalf of steamship lines, motor carriers, and intermodal marketing companies with rail carriers serving as long-distance haulers. KCS serves and supports the U.S. and Mexican markets, as well as cross-border traffic between the U.S. and Mexico. In light of the importance of trade between Asia and North America, the Company believes the Port of Lazaro Cardenas continues to be a strategically beneficial location for ocean carriers, manufacturers and retailers. Equally important, the increase in foreign direct investment in Mexico has caused the KCS Mexico/U.S. cross border corridor to emerge as an increasingly important tool for the freight flow. The Company also provides premium service to customers over its line from Dallas through the Meridian Speedway— a critical link in creating the most direct route between the southwest and southeast/northeast U.S.
Automotive. KCS provides rail transportation to every facet of the automotive industry supply chain, including automotive manufacturers, assembly plants and distribution centers throughout North America. In addition, KCS transports finished vehicles imported and exported to and from various countries through a distribution facility at the Port of Lazaro Cardenas.
GOVERNMENT REGULATION
The Company’s United States operations are subject to federal, state and local laws and regulations generally applicable to all businesses subject to federal preemption under certain circumstances. Rail operations are also subject to the regulatory jurisdiction of the Surface Transportation Board (“STB”), the Federal Railroad Administration (“FRA”) of the U.S. Department of Transportation (“DOT”), the Occupational Safety and Health Administration (“OSHA”), as well as other federal and state regulatory agencies. The STB has jurisdiction over disputes and complaints involving certain rates, routes and services, the sale or abandonment of rail lines, applications for line extensions and construction, and consolidation or merger with, or acquisition of control of, rail common carriers. DOT and OSHA each has jurisdiction under several federal statutes over a number of safety and health aspects of rail operations, including the transportation of hazardous materials. In 2008, the President of the United States signed the Rail Safety Improvement Act of 2008 into law, which, among other things, revised hours of service for train and certain other employees and mandated implementation of PTC at certain locations by the end of 2015. PTC is a technology designed to help prevent train-to-train collisions, overspeed derailments, incursions into rail work zones, and entry into main line track if a switch is misaligned at certain locations, including main line track where toxic inhalation hazard or poison inhalation hazard movements occur or where passenger operations occur. The Surface Transportation Extension Act of 2015 amended the PTC deadline set by the the Rail Safety Improvement Act to require implementation of PTC by the end of 2018, which was extended to December 31, 2020 for KCS, as certain other criteria were satisfied. By the end of 2018, the Company implemented PTC on all required sections of its rail network, locomotives and wayside assets. The Company will continue to work with the Class I freight railroads and Amtrak to complete interoperability on or before December 31, 2020. PTC will add to operating costs, increase the number of employees the Company employs and require KCS to make significant investments in new safety technology.
KCS’s U.S. subsidiaries are subject to extensive federal, state and local environmental regulations. These laws cover discharges to water, air emissions, toxic substances, and the generation, handling, storage, transportation and disposal of waste and hazardous materials. These regulations have the effect of increasing the costs, risks and liabilities associated with rail operations. Environmental risks are also inherent in rail operations, which frequently involve transporting chemicals and other hazardous materials.
Primary regulatory jurisdiction for the Company’s Mexican operations is overseen by the Mexican Agencia Reguladora del Transporte Ferroviario (“Regulatory Agency of Rail Transportation” or “ARTF”). The ARTF establishes regulations concerning railway safety and operations, and is responsible for resolving disputes between railways and customers. KCSM must register its maximum rates with the ARTF and make regular reports to the ARTF and the Secretaría de Comunicaciones y Transportes (“Secretary of Communications and Transportation” or “SCT”). KCSM must provide reports on investments, traffic volumes, theft and vandalism on the general right of way, customer complaints, fuel consumption, number of locomotives, railcars and employees, and activities around maintenance of way, sidings and spurs, among other financial information and reports. The Company may freely set rates on a non-discriminatory basis. At any time, the ARTF may request additional information regarding the determination of such rates and may issue recommendations with respect to proposed rate increases. If the ARTF or another party considers there to be no effective competition, they may request an opinion from the Comisión Federal de Competencia Económica (“Mexican Antitrust Commission” or “COFECE”) regarding market conditions. If the COFECE determines that there is no effective competition for particular movements, the ARTF could set rates for those movements or grant limited trackage rights to another railroad while the condition of no effective competition remains.
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KCSM holds a concession from the Mexican government until June 2047 (exclusively through 2027, subject to certain trackage and haulage rights granted to other concessionaires), which is renewable under certain conditions for additional periods of up to 50 years. The Concession authorizes KCSM to provide freight transportation services over north-east rail lines which are a primary commercial corridor of the Mexican railroad system. KCSM is required to provide freight railroad services to all users on a fair and non-discriminatory basis and in accordance with efficiency and safety standards approved periodically by the Mexican government. KCSM has the right to use, but does not own, all track and buildings that are necessary for the rail lines’ operation. KCSM is obligated to maintain the right of way, track structure, buildings and related maintenance facilities to the operational standards specified in the Concession agreement and to return the assets in that condition at the end of the Concession period. During the remainder of the Concession period, KCSM is required to pay the Mexican government an annual concession duty equal to 1.25% of gross revenues. The ARTF may request information to verify KCSM´s compliance with the Concession and any applicable regulatory framework.
The Company’s 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.
Noncompliance with applicable legal provisions may result in the imposition of fines, temporary or permanent shutdown of operations or other injunctive relief, criminal prosecution or, with respect to KCSM, the termination of the Concession. KCS maintains environmental provisions that are believed by management to be appropriate with respect to known and existing environmental contamination of its properties that KCS may be responsible to remedy. In addition, KCS’s subsidiaries are party to contracts and other legally binding obligations by which previous owners of certain facilities now owned by KCS are responsible to remedy contamination of such sites remaining from their previous ownership.
Government regulations are further discussed within Item 7, Management’s Discussion and Analysis of Financial Information and Results of Operations — Other Matters.
COMPETITION
The Company competes against other railroads, many of which are much larger and have significantly greater financial and other resources. The railroad industry in North America is dominated by a few very large carriers. The larger U.S. western railroads (BNSF Railway Company and Union Pacific Railroad Company), in particular, are significant competitors of KCS because of their substantial resources and competitive routes.
In Mexico, KCSM’s operations are subject to competition from other railroads, particularly Ferrocarril Mexicano, S.A. de C.V. (“Ferromex”) and Ferrosur, S.A. de C.V. (“Ferrosur”), both controlled by Grupo Mexico S.A.B. de C.V. Ferromex and Ferrosur together are much larger and have significantly greater financial and other resources than KCSM, serving most of the major ports and cities in Mexico and together owning fifty percent of FTVM, which serves industries located within Mexico City.
The ongoing impact of past and future rail consolidation is uncertain. However, KCS believes that its investments and strategic alliances continue to competitively position the Company to attract additional rail traffic throughout its rail network.
The Company is subject to competition from motor carriers, barge lines and other maritime shipping, which compete across certain routes in KCS’s operating areas. In the past, truck carriers have generally eroded the railroad industry’s share of total transportation revenues. Intermodal traffic and certain other traffic face highly price sensitive competition, particularly from motor carriers. However, rail carriers, including KCS, have placed an emphasis on competing in the intermodal marketplace and working with motor carriers to provide end-to-end transportation of products.
While deregulation of U.S. freight rates has enhanced the ability of railroads to compete with each other and with alternative modes of transportation, this increased competition has generally resulted in downward pressure on freight rates since deregulation. Competition with other railroads and other modes of transportation is generally based on the rates charged, the quality and reliability of the service provided and the quality of the carrier’s equipment for certain commodities.
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RAIL SECURITY
The Company and its rail subsidiaries have continued to research, develop and implement multidisciplinary approaches to secure the Company’s assets and personnel against transnational criminal organizations that actively target transportation networks. In addition, the Company has developed a variety of vertically integrated strategies to mitigate the risk terrorist attacks could pose to the Company, its personnel and assets. Many of the specific measures the Company utilizes for these efforts are required to be kept confidential through arrangements with government agencies, such as the Department of Homeland Security (“DHS”), or through jointly-developed and implemented strategies and plans with connecting carriers.
KCSR and KCSM developed a proprietary security plan based on an industry-wide plan developed by the Association of American Railroads (“AAR”) members which focuses on comprehensive risk assessments in five areas — hazardous materials; train operations; critical physical assets; military traffic; and information technology and communications. The security plan is kept confidential, with access to the plan tightly limited to members of management with direct security and anti-terrorism implementation responsibilities. The Company participates with other AAR members in periodic drills under the industry plan to test and refine its various provisions.
To protect the confidentiality and sensitivity of both the AAR plans and the proprietary strategies the Company has developed to safeguard against criminal enterprises, terrorism, and other security and safety threats, the following paragraphs will provide only a general overview of some of these efforts.
The Company’s security activities range from periodically providing security awareness updates to KCS employees and including safety and security information on the Company’s internet website (which can be found under the “Corporate Responsibility” tab at www.kcsouthern.com) to its ongoing implementation of security plans for rail facilities in areas labeled by the DHS as High Threat Urban Areas (“HTUAs”). The Company’s other activities to bolster security against terrorism include, but are not limited to, the following:
• | Conferring regularly with other railroads’ security personnel and with industry experts on security issues; |
• | Routing shipments of certain chemicals, which might be toxic if inhaled, pursuant to federal regulations; |
• | Initiating a series of over 20 voluntary action items agreed to between AAR and DHS as enhancing security in the rail industry; |
• | Conducting constant and targeted security training as part of the scheduled training for operating employees and managers; |
• | Developing smartphone applications to ensure immediate information, live video and pictures from security supervisors and protection assets pertaining to potential operational risks; |
• | Developing a multi-layered security model using high-speed digital imaging, system velocity and covert and overt security filters to mitigate the risk of illicit activity; |
• | Measuring key security metrics to ensure positive risk mitigation and product integrity trends; |
• | Performing constant due diligence with the existing security model and by benchmarking rail security on a world-wide basis to monitor threat streams related to rail incidents; |
• | Implementing a Tactical Intelligence Center by KCSM, which provides constant training with core members in new technology helping to prevent, detect, deter, deny and respond to potentially illicit activities; and |
• | Deploying an array of non-intrusive technologies including, but not limited to, digital video surveillance and analytics as part of an intelligent video security solution, including a closed circuit television platform with geo-fencing for intrusion detection, to allow for remote viewing access to monitor ports of entry, intermodal and rail yards. |
In addition, the Company utilizes dedicated security personnel with extensive special operations forces, intelligence, and law enforcement backgrounds to oversee the ongoing and increasingly complex security efforts of the Company in both the United States and Mexico. While the risk of theft and vandalism is higher in Mexico, KCSM remains among the safest methods of transportation for freight shipments in Mexico. KCSM’s record in rail safety is due in large part to the implementation of a multi-layered safety and security process throughout the KCSM network. In addition to having its own internal system, the process is connected to, and supported by a high level of federal, state and local law enforcement. A primary focus of this effort involves maintaining constant due diligence, intelligence and counterintelligence operations, technology-reporting applications and active vigilance while enhancing overall system velocity, which reduces the residual risk for incidents to occur.
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RAILWAY LABOR ACT
Labor relations in the U.S. railroad industry are subject to extensive governmental regulation under the Railway Labor Act (“RLA”). Under the RLA, national labor agreements are renegotiated on an industry-wide scale when they become open for modification, but their terms remain in effect until new agreements are reached or the RLA’s procedures (which include mediation, cooling-off periods, and the possibility of presidential intervention) are exhausted. Contract negotiations with the various unions generally take place over an extended period of time and the Company rarely experiences work stoppages during negotiations. Wages, health and welfare benefits, work rules and other issues have traditionally been addressed during these negotiations.
COLLECTIVE BARGAINING
Approximately 75% of KCSR employees are covered by collective bargaining agreements. These agreements do not have expiration dates, but rather remain in place until modified by subsequent agreements. KCSR participates in industry-wide multi-employer bargaining as a member of the National Carriers’ Conference Committee (the “NCCC”), as well as local bargaining for agreements that are limited to KCSR's property. Multi-employer agreements are subject to a procedure that allows requests for changes to be served every five years. Long-term agreements were reached voluntarily or through the arbitration process during 2017 and 2018 covering all of the participating unions. These agreements will be in effect through December 2019.
KCSM Servicios union employees are covered by one labor agreement, which was signed on April 16, 2012, between KCSM Servicios and the Sindicato de Trabajadores Ferrocarrileros de la República Mexicana (“Mexican Railroad Union”), and which remains in effect during the period of the Concession, for the purpose of regulating the relationship between the parties. Approximately 80% of KCSM Servicios employees are covered by this labor agreement. The compensation terms under this labor agreement are subject to renegotiation on an annual basis and all other benefits are subject to negotiation every two years. The union labor negotiations with the Mexican Railroad Union have not historically resulted in any strike, boycott or other disruption in KCSM’s business operations. During the third quarter of 2018, KCSM Servicios and the Mexican Railroad Union concluded their negotiation over compensation terms for the period covering July 1, 2018, to June 30, 2019. The finalization of the compensation terms did not have a significant effect on the consolidated financial statements.
EXECUTIVE OFFICERS OF KCS AND SUBSIDIARIES
All executive officers are elected annually and serve at the discretion of the Board of Directors. All of the executive officers have employment agreements with KCS and/or its subsidiaries. The mailing address of the principal executive officers other than Mr. Zozaya is 427 W. 12th Street, Kansas City, Missouri 64105. Mr. Zozaya’s mailing address is Montes Urales No. 625, Col. Lomas de Chapultepec, C.P. 11000, Mexico D.F.
Patrick J. Ottensmeyer — President and Chief Executive Officer— 61 — Served in this capacity since July 1, 2016. Mr. Ottensmeyer has been a director of KCS since July 1, 2016 and served as President of KCS since March 1, 2015. He served as Executive Vice President Sales and Marketing of KCS from October 16, 2008 through March 1, 2015. Mr. Ottensmeyer joined KCS in May 2006 as Executive Vice President and Chief Financial Officer.
Warren K. Erdman — Executive Vice President — Administration and Corporate Affairs — 60 — Served in this capacity since April 2010. Mr. Erdman served as Executive Vice President — Corporate Affairs from October 2007 until April 2010. He served as Senior Vice President — Corporate Affairs of KCS and KCSR from January 2006 to September 2007. Mr. Erdman served as Vice President — Corporate Affairs of KCS from April 15, 1997 to December 31, 2005 and as Vice President — Corporate Affairs of KCSR from May 1997 to December 31, 2005. Prior to joining KCS, Mr. Erdman served as Chief of Staff to United States Senator Kit Bond of Missouri from 1987 to 1997.
Brian D. Hancock — Executive Vice President and Chief Innovation Officer — 53 — Served in this capacity since October 1, 2018. Mr. Hancock served as Executive Vice President and Chief Marketing Officer from August 2015 until September 2018. Prior to joining KCS, Mr. Hancock served as Senior Vice President of Supply Chain for Family Dollar Stores, Inc. from 2013 to July 2015. From 2011 to 2013, Mr. Hancock served as President – North America for The Martin – Brower Company, L.L.C. From 2005 to 2011, he served as Vice President – Global Supply Chain for Whirlpool Corporation.
Jeffrey M. Songer — Executive Vice President and Chief Operating Officer — 49 — Served in this capacity since March 2016. Mr. Songer served as Senior Vice President Engineering and Chief Transportation Officer of the Company from August 2014 to February 2016 and as Vice President and Chief Engineer for KCSR from June 2012 to July 2014. Prior to serving as
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KCSR’s Vice President and Chief Engineer, Mr. Songer served as Assistant Vice President — Engineering and Planning from March 2011 to June 2012, and as its General Director — Planning, Scheduling & Administration from January 2007 to March 2011.
Michael W. Upchurch — Executive Vice President and Chief Financial Officer — 58 — Served in this capacity since October 16, 2008. Mr. Upchurch joined KCS in March 2008 as Senior Vice President Purchasing and Financial Management. From 1990 through September 2006, Mr. Upchurch served in various senior financial leadership positions at Sprint Corporation, including Senior Vice President Financial Operations, Senior Vice President Finance Sprint Business Solutions and Senior Vice President Finance Long Distance Division.
José Guillermo Zozaya Delano — President and Executive Representative — KCSM — 66 — Served in this position since April 20, 2006. Mr. Zozaya has 35 years of experience in law and government relations, most recently as the Legal and Government Relations Director for ExxonMobil México, S.A. de C.V., where he spent nine years prior to joining KCSM.
Lora S. Cheatum — Senior Vice President — Human Resources — 62 — Served in this capacity since joining KCS in October 2014. Ms. Cheatum previously served as Senior Vice President Global Human Resources of Layne Christensen from 2012 to October 2014. From 2010 to 2012, she served as Director — Field Operations at Fitness Together Holdings, Inc. Ms. Cheatum spent nine years with Kansas City Power & Light, from 2001 to 2010, where she was Vice President of Procurement and previously as Vice President Human Resources.
Michael J. Naatz — Executive Vice President and Chief Marketing Officer — 53 — Served in this capacity since October 1, 2018. Mr. Naatz served as Senior Vice President Operations Support and Chief Information Officer from August 2014 until September 2018 and as Senior Vice President and Chief Information Officer of the Company from May 2012 to July 2014. Prior to joining KCS, Mr. Naatz served as President of USF Holland, a YRC Worldwide, Inc. (“YRCW”) company, from 2011 to May 2012. From 2010 to 2011, Mr. Naatz served as President and Chief Customer Officer - Customer Care Division at YRCW. From 2008 to 2010, he served as Executive Vice President and Chief Information & Service Officer at YRCW. From 2005 to 2007, he served as President — Enterprise Services Division at YRCW. From 1994 to 2005, he held various leadership positions with USF Corporation.
Suzanne M. Grafton — Vice President and Chief Accounting Officer — 43 — Served in this capacity since July 24, 2017. Ms. Grafton served as Vice President of Audit and Enterprise Risk Management of the Company from April 2016 to July 2017 and as Vice President of Accounting from May 2014 to March 2016. From September 2006 to May 2014, Ms. Grafton served in various accounting leadership positions at KCS.
William J. Wochner — Senior Vice President and Chief Legal Officer — 71 — Served in this capacity since February 2007. Effective March 31, 2019, Mr. Wochner will be retiring. He served as Vice President and Interim General Counsel from December 2006 to January 2007. From September 2006 to December 2006, Mr. Wochner served as Vice President and Associate General Counsel. From March 2005 to September 2006, Mr. Wochner served as Vice President Sales and Marketing/Contracts for KCSR. From February 1993 to March 2005, Mr. Wochner served as Vice President and General Solicitor of KCSR.
Adam J. Godderz — General Counsel and Corporate Secretary — 44 — Served in this capacity since January 1, 2019. Mr. Godderz served as Associate General Counsel and Corporate Secretary of the Company from June 2018 to December 2018 and as Vice President of Labor Relations and Corporate Secretary from November 2015 to May 2018. From January 2013 to November 2015, Mr. Godderz served as Associate General Counsel and Corporate Secretary. From September 2007 to January 2013, Mr. Godderz served as Associate General Counsel at KCS.
There are no arrangements or understandings between the executive officers and any other person pursuant to which the executive officer was or is to be selected as an officer of KCS, except with respect to the executive officers who have entered into employment agreements designating the position(s) to be held by the executive officer.
None of the above officers is related to another, or to any of the directors of KCS.
AVAILABLE INFORMATION
KCS’s website (www.kcsouthern.com) provides at no cost KCS’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, and amendments to those reports, as soon as reasonably practicable after the electronic filing of these reports is made with the Securities and Exchange Commission. In addition, KCS’s corporate governance guidelines, ethics and legal compliance policy, and the charters of the Audit Committee, the Finance and Strategic
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Investments Committee, the Nominating and Corporate Governance Committee and the Compensation and Organization Committee of the Board of Directors are available on KCS’s website. These guidelines, policies and charters are available in print without charge to any stockholder requesting them. Written requests for these materials may be made to the Corporate Secretary, P.O. Box 219335, Kansas City, Missouri 64121-9335 (or if by express delivery to 427 West 12th Street, Kansas City, Missouri 64105). From time to time, KCS publicly designates material information by posting it on the website, investors.kcsouthern.com, in lieu of press releases.
See Item 8, Financial Statements and Supplementary Data — Note 1, Description of the Business and Note 18, Geographic Information for more information on the description and general development of the Company’s business and financial information about geographic areas.
Item 1A. | Risk Factors |
KCS U.S. and Mexico rail common carrier subsidiaries are required by United States and Mexican laws, respectively, to transport hazardous materials, which could expose KCS to significant costs and claims.
Under United States federal statutes and applicable Mexican laws, KCS’s common carrier responsibility requires it to transport hazardous materials. Any rail accident or other incident or accident on KCS’s network, facilities, or at the facilities of KCS’s customers involving the release of hazardous materials, including toxic inhalation hazard materials, could involve significant costs and claims for personal injury, property damage, and environmental penalties and remediation in excess of the Company’s insurance coverage for these risks, which could have a material adverse effect on KCS’s consolidated financial statements.
KCS’s business is subject to regulation by federal, state and local legislatures and agencies that could impose significant cost on the Company’s business operations.
KCS rail subsidiaries are subject to legislation and regulation enacted by federal, state and local legislatures and agencies in the U.S. and Mexico with respect to railroad operations. Government regulation of the railroad industry is a significant determinant of the competitiveness and profitability of railroads. Changes in legislation or regulation could have a negative impact on KCS’s ability to negotiate prices for rail services, could negatively affect competition among rail carriers, or could negatively impact operating practices, resulting in reduced efficiency, increased operating costs or increased capital investment, all of which could result in a material adverse effect on KCS’s consolidated financial statements.
New economic regulation in the U.S. or Mexico in current or future proceedings could change the regulatory framework within which the Company operates which could materially change the Company's business and have a material adverse effect on the Company's consolidated financial statements.
As part of the Rail Safety Improvement Act of 2008 in the United States, Class I railroad carriers and passenger and commuter rail operators must implement PTC, a technology designed to help prevent train-to-train collisions, overspeed derailments, incursions into rail work zones, and entry into main line track if a switch is misaligned. PTC is required to be implemented at certain locations, including main line track where toxic inhalation hazard movements regularly occur or where passenger operations occur. The Surface Transportation Extension Act of 2015 amended the PTC deadline set by the Rail Safety Improvement Act to require implementation of PTC by the end of 2018, which was extended to December 31, 2020 for KCS, as certain other criteria were satisfied. PTC will add to operating costs, increase the number of employees the Company employs and require KCS to make significant investments in new safety technology. KCS’s failure to meet deadlines, including any extension, could result in fines, service interruptions or penalties and could have a material adverse effect on the Company’s consolidated financial statements.
KCS’s failure or inability to comply with applicable laws and regulations could have a material adverse effect on the Company’s consolidated financial statements and operations, including fines, penalties, or limitations on operating activities until compliance with applicable requirements is achieved. Congress and government agencies may change the legislative or regulatory framework within which the Company operates without providing any recourse for any adverse effects on the Company’s business that occur as a result of such change. Additionally, some of the regulations require KCS to obtain and maintain various licenses, permits and other authorizations. Any failure to obtain or maintain these licenses, permits, and other authorizations could have a material adverse effect on KCS’s business operations.
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KCSM’s Mexican Concession is subject to revocation or termination in certain circumstances which would prevent KCSM from conducting rail operations over the Concession and would have a material adverse effect on the Company’s consolidated financial statements.
KCSM operates under the Concession granted by the Mexican government until June 2047, which is renewable for an additional period of up to 50 years, subject to certain conditions. The Concession gives KCSM exclusive rights to provide freight transportation services over its rail lines through 2027 (the first 30 years of the 50-year Concession), subject to certain trackage and haulage rights granted to other concessionaires. The SCT and ARTF, which are principally responsible for regulating railroad services in Mexico, have broad powers to monitor KCSM’s compliance with the Concession, and they can require KCSM to supply them with any technical, administrative and financial information they request. Among other obligations, KCSM must comply with the investment commitments established in its business plan, which forms an integral part of the Concession, and must update the plan every three years. The SCT treats KCSM’s business plans confidentially. The SCT and ARTF also monitor KCSM’s compliance with efficiency and safety standards established in the Concession. The SCT and ARTF review, and may amend, these standards from time to time.
Under the Concession, KCSM has the right to operate its rail lines, but it does not own the land, roadway or associated structures. If the Mexican government legally terminates the Concession, it would own, control, and manage such public domain assets used in the operation of KCSM’s rail lines. All other property not covered by the Concession, including all locomotives and railcars otherwise acquired, would remain KCSM’s property. In the event of early termination, or total or partial revocation of the Concession, the Mexican government would have the right to cause the Company to lease all service-related assets to it for a term of at least one year, automatically renewable for additional one-year terms up to five years. The amount of rent would be determined by experts appointed by KCSM and the Mexican government. The Mexican government must exercise this right within four months after early termination or revocation of the Concession. In addition, the Mexican government would also have a right of first refusal with respect to certain transfers by KCSM of railroad equipment within 90 days after revocation of the Concession.
The Mexican government may also temporarily seize control of KCSM’s rail lines and its assets in the event of a natural disaster, war, significant public disturbance or imminent danger to the domestic peace or economy. In such a case, the SCT may restrict KCSM’s ability to exploit the Concession in such manner as the SCT deems necessary under the circumstances, but only for the duration of any of the foregoing events. Mexican law requires that the Mexican government pay compensation if it effects a statutory appropriation for reasons of the public interest. With respect to a temporary seizure due to any cause other than international war, the Mexican Regulatory Railroad Service Law and regulations provide that the Mexican government will indemnify an affected concessionaire for an amount equal to damages caused and losses suffered. However, these payments may not be sufficient to compensate KCSM for its losses and may not be made timely.
The SCT may revoke the Concession if KCSM is sanctioned for the same cause at least three times within a period of five years for any of the following: unjustly interrupting the operation of its rail lines or for charging rates higher than those it has registered with the ARTF; unlawfully restricting the ability of other Mexican rail operators to use its rail lines; failing to make payments for damages caused during the performance of services; failing to comply with any term or condition of the Mexican Regulatory Railroad Service Law and regulations or the Concession; failing to make the capital investments required under its three-year business plan filed with the SCT; or failing to maintain an obligations compliance bond and insurance coverage as specified in the Mexican Regulatory Railroad Service Law and regulations. In addition, the Concession would terminate automatically if KCSM changes its nationality or assigns or creates any lien on the Concession, or if there is a change in control of KCSM without the SCT’s approval. The SCT may also terminate the Concession as a result of KCSM’s surrender of its rights under the Concession, or for reasons of public interest or upon KCSM’s liquidation or bankruptcy. If the Concession is terminated or revoked by the SCT for any reason, KCSM would receive no compensation and its interest in its rail lines, and all other fixtures covered by the Concession, as well as all improvements made by it, would revert to the Mexican government. Revocation or termination of the Concession could have a material adverse effect on the Company’s consolidated financial statements.
KCS’s ownership of KCSM and operations in Mexico subject it to economic and political risks.
The Mexican government has exercised, and continues to exercise, significant influence over the Mexican economy. Accordingly, Mexican governmental actions concerning the economy and state-owned enterprises could have a significant impact on Mexican private sector entities in general and on KCSM’s operations in particular. KCS cannot predict the impact that the political landscape, including multiparty rule and civil disobedience, will have on the Mexican economy. Furthermore,
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KCS’s consolidated financial statements and prospects may be affected by currency fluctuations, inflation, interest rates, regulation, taxation and other political, social and economic developments in or affecting Mexico.
The Mexican economy in the past has suffered balance of payment deficits and shortages in foreign exchange reserves. Although Mexico has imposed foreign exchange controls in the past, there are currently no exchange controls in Mexico. Any restrictive exchange control policy could adversely affect KCS’s ability to obtain U.S. dollars or to convert Mexican pesos (“pesos” or “Ps.”) into dollars for purposes of making payments. This could have a material adverse effect on KCS’s consolidated financial statements.
The social and political situation in Mexico could adversely affect the Mexican economy and changes in laws, public policies and government programs could be enacted, which could have a material adverse effect on KCS’s consolidated financial statements.
Downturns in the United States economy or in trade between the United States and Asia or Mexico and fluctuations in the peso-dollar exchange rates could have adverse effects on KCS’s consolidated financial statements.
The level and timing of KCS’s Mexican business activity is heavily dependent upon the level of United States-Mexican trade and the effects of current or future multinational trade agreements on such trade. The Mexican operations depend on the United States and Mexican markets for the products KCSM transports, the relative position of Mexico and the United States in these markets at any given time, and tariffs or other barriers to trade. Failure to preserve free trade provisions, or any other action imposing import duties or border taxes, could negatively impact KCS customers and the volume of rail shipments, and could have a material adverse effect on KCS’s consolidated financial statements.
Downturns in the United States or Mexican economies or in trade between the United States and Mexico could have material adverse effects on KCS’s consolidated financial statements and the Company’s ability to meet debt service obligations. In addition, KCS has invested significant amounts in developing its intermodal operations, including the Port of Lazaro Cardenas, in part to provide Asian importers with an alternative to the west coast ports of the United States, and the level of intermodal traffic depends, to an extent, on the volume of Asian shipments routed through Lazaro Cardenas. Reduction in trading volumes, which may be caused by factors beyond KCS’s control, including increased government regulations regarding the safety and quality of Asian-manufactured products, could have a material adverse effect on KCS’s consolidated financial statements.
Additionally, fluctuations in the peso-dollar exchange rates could lead to shifts in the types and volumes of Mexican imports and exports. Although a decrease in the level of exports of some of the commodities that KCSM transports to the United States may be offset by a subsequent increase in imports of other commodities KCSM hauls into Mexico and vice versa, any offsetting increase might not occur on a timely basis, if at all. Future developments in United States-Mexican trade beyond the Company’s control may result in a reduction of freight volumes or in an unfavorable shift in the mix of products and commodities KCSM carries.
Severe weakening of the peso against the U.S. dollar may result in disruption of the international foreign exchange markets and may limit the ability to transfer pesos or to convert pesos into U.S. dollars for the purpose of making timely payments of interest and principal on the non-peso denominated indebtedness. Although the Mexican government currently does not restrict, and for many years has not restricted, the right or ability of Mexican or foreign persons or entities to convert pesos into U.S. dollars or to transfer foreign currencies out of Mexico, the Mexican government could, as in the past, institute restrictive exchange rate policies that could limit the ability to transfer or convert pesos into U.S. dollars or other currencies for the purpose of making timely payments and contractual commitments. Devaluation or depreciation of the peso against the U.S. dollar may also adversely affect U.S. dollar prices for KCS’s securities.
Fluctuations in the peso-dollar exchange rates also have an effect on KCS’s consolidated financial statements. A weakening of the peso against the U.S. dollar would cause reported peso-denominated revenues and expenses to decrease, and could increase reported foreign exchange loss due to the Company’s net monetary assets that are peso-denominated. Exchange rate variations also affect the calculation of taxes under Mexican income tax law, and a strengthening of the peso against the U.S. dollar could cause an increase in the Company’s cash tax obligation and effective income tax rate.
Severe weather or other natural disasters could result in significant business interruptions and expenditures.
The Company’s operations may be affected by severe weather or other natural disasters. The Company operates in and along the Gulf of Mexico, and its facilities may be materially adversely affected by hurricanes, floods and other extreme
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weather conditions that could also adversely affect KCS’s shipping, agricultural, chemical and other customers. Severe weather or other natural disasters could result in significant business interruption and could have a material adverse effect on KCS’s consolidated financial statements.
KCS’s business may be adversely affected by changes in general economic or other conditions.
KCS’s operations may be materially adversely affected by changes in the economic conditions of the industries and geographic areas that produce and consume the freight that KCS transports. The relative strength or weakness of the United States and Mexican economies affects the businesses served by KCS. A significant and sustained decrease in crude oil prices could adversely affect the transport of crude oil by rail to the U.S. Gulf region as well as negatively impact railroad volumes related to equipment and other materials that support crude oil production. Prolonged negative changes in domestic and global economic conditions or disruptions of either or both of the financial and credit markets, including the availability of short and long-term debt financing, may affect KCS, as well as the producers and consumers of the commodities that KCS transports and may have a material adverse effect on KCS’s consolidated financial statements.
The transportation industry is highly cyclical, generally tracking the cycles of the world economy. Although transportation markets are affected by general economic conditions, there are numerous specific factors within each particular market that may influence operating results. Some of KCS’s customers do business in industries that are highly cyclical, including the energy, automotive, housing and agriculture industries. Any downturn or change in government policy in these industries could have a material adverse effect on operating results. Also, some of the products transported have had a historical pattern of price cyclicality which has typically been influenced by the general economic environment and by industry capacity and demand. KCS cannot assure that prices and demand for these products will not decline in the future, adversely affecting those industries and, in turn, could have a material adverse effect on the Company’s consolidated financial statements.
Significant reductions in the volume of rail shipments due to economic or other conditions could have a material adverse effect on KCS’s consolidated financial statements.
KCS depends on the stability, availability and security of its information technology systems to operate its business.
KCS relies on information technology in all aspects of its business. A significant disruption or failure of its information technology systems, including its computer hardware, software, communications equipment, wayside equipment or locomotive onboard equipment could result in service interruptions, safety failures, security failures, regulatory compliance failures or other operational difficulties.
The security risks associated with information technology systems have increased in recent years because of the increased sophistication, activities and evolving techniques of perpetrators of cyber attacks. A failure in or breach of KCS’s information technology security systems, or those of its third party service providers, as a result of cyber attacks or unauthorized access to its network could disrupt KCS’s business, result in the disclosure or misuse of confidential or proprietary information, increase its costs and/or cause losses and reputational damage. KCS also confronts the risk that a terrorist or nation-state sponsored group may seek to use its property, including KCS’s information technology systems, to inflict major harm.
A significant disruption, failure or unauthorized access of KCS’s information technology system could have a material adverse effect on KCS’s consolidated financial statements.
Capacity constraints could adversely affect service and operating efficiency.
KCS may experience capacity constraints due to increased demand for rail services, unavailability of equipment, crew shortages, or extreme weather. Also, due to the interconnectivity between all railroads, especially in the U.S., congestion on other railroads could result in operational inefficiencies for KCS. Traffic congestion experienced in the U.S. or Mexican railroad system may result in overall traffic congestion which would impact the ability to move traffic to and from Mexico, which could result in operational inefficiencies for KCS and could have a material adverse effect on KCS’s operations.
Significant expansions in the capacity of the Company’s network can require a substantial amount of time and investment. Although KCS constantly monitors its network in an effort to optimize its rail services, there can be no assurance that such measures will adequately address capacity constraints on a timely basis.
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KCS may be subject to various claims and litigation that could have a material adverse effect on KCS’s consolidated financial statements.
The Company may be exposed to the potential of various claims and litigation related to labor and employment, personal injury, commercial disputes, freight loss and other property damage, and other matters that arise in the normal course of business. Any material changes to litigation trends or a catastrophic rail accident or series of accidents involving any or all of property damage, personal injury, and environmental liability could have a material adverse effect on KCS’s consolidated financial statements.
KCS competes against other railroads and other transportation providers.
The Company’s domestic and international operations are subject to competition from other railroads, as well as from truck carriers, barge lines, and other maritime shippers. Many of KCS’s rail competitors are much larger and have significantly greater financial and other resources than KCS, which may enable rail competitors to reduce rates and make KCS’s freight services less competitive. KCS’s ability to respond to competitive pressures by matching rate reductions and decreasing rates without adversely affecting gross margins and operating results will depend on, among other things, the ability to reduce operating costs. KCS’s failure to respond to competitive pressures, and particularly rate competition, in a timely manner could have a material adverse effect on the Company’s consolidated financial statements.
The railroad industry is dominated by a few large carriers. These larger railroads could attempt to use their size and pricing power to block other railroads’ access to gateways and routing options that are currently and have historically been available. In addition, if there is future consolidation in the railroad industry in the United States or Mexico, there can be no assurance that it will not have a material adverse effect on the Company’s consolidated financial statements.
Trucking, maritime, and barge competitors, while able to provide rate and service competition to the railroad industry, are able to use public rights-of-way, require substantially smaller capital investment and maintenance expenditures than railroads and allow for more frequent and flexible scheduling. Continuing competitive pressures, any reduction in margins due to competitive pressures, developments that increase the quality or decrease the cost of alternative modes of transportation in the locations in which the Company operates, or legislation or regulations that provide motor carriers with additional advantages, such as increased size of vehicles and reduced weight restrictions, could result in downward pressure on freight rates, which in turn could have a material adverse effect on the Company’s consolidated financial statements.
A key part of KCS’s growth strategy is based upon the conversion of truck traffic to rail. There can be no assurance the Company will succeed in its efforts to convert traffic from truck to rail transport or that the customers already converted will be retained. If the railroad industry in general is unable to preserve its competitive advantages vis-à-vis the trucking industry, revenue growth could be adversely affected. Additionally, revenue growth could be affected by, among other factors, an expansion in the availability, or an improvement in the quality, of the trucking services offered by carriers resulting from regulatory and administrative interpretations and implementation of certain provisions of current or future multinational trade agreements, and KCS’s inability to grow its existing customer base and capture additional cargo transport market share because of competition from the shipping industry and other railroads.
KCS’s business strategy, operations and growth rely significantly on agreements with other railroads and third parties.
Operation of KCS’s rail network and its plans for growth and expansion rely significantly on agreements with other railroads and third parties, including joint ventures and other strategic alliances, as well as interchange, trackage rights, haulage rights and marketing agreements with other railroads and third parties that enable KCS to exchange traffic and utilize trackage the Company does not own. KCS’s ability to provide comprehensive rail service to its customers depends in large part upon its ability to maintain these agreements with other railroads and third parties, and upon the performance of the obligations under the agreements by the other railroads and third parties. The termination of, or the failure to renew, these agreements could have a material adverse effect on KCS’s consolidated financial statements. KCS is also dependent in part upon the financial strength and efficient performance of other railroads. There can be no assurance that KCS will not be materially adversely affected by operational or financial difficulties of other railroads.
KCS is subject to environmental regulations, which may impose significant costs on the Company’s business operations.
KCS subsidiaries’ operations are subject to environmental regulation enacted by federal, state and local legislatures in the U.S. and Mexico. From time to time, certain KCS facilities have not been in compliance with environmental health and safety
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laws and regulations and there can be no assurance that KCS will always be in compliance with such laws and regulations in the future. Environmental liability under federal and state law in the United States can also extend to previously owned or operated properties, leased properties and properties owned by third parties, as well as to properties currently owned and used by the Company. Environmental liabilities may also arise from claims asserted by adjacent landowners or other third parties. Given the nature of its business, the Company incurs, and expects to continue to incur, environmental compliance costs, including, in particular, costs necessary to maintain compliance with requirements governing chemical and hazardous material shipping operations, refueling operations and repair facilities. KCS presently has environmental investigation and remediation obligations at certain sites, and will likely incur such obligations at additional sites in the future.
The Company’s Mexican subsidiaries’ operations are subject to Mexican federal and state laws and regulations relating to the protection of the environment, including standards for, among other things, water discharge, water supply, emissions, noise pollution, hazardous substances and transportation and handling of hazardous and solid waste. Under applicable Mexican law and regulations, administrative and criminal proceedings may be brought and economic sanctions imposed against companies that violate environmental laws, and non-complying facilities may be temporarily or permanently closed. KCSM is also subject to the laws of various jurisdictions with respect to the discharge of materials into the environment and to environmental laws and regulations issued by the governments of each of the Mexican states in which KCSM’s facilities are located. The terms of KCSM’s Concession from the Mexican government also impose environmental compliance obligations on KCSM. Failure to comply with any environmental laws or regulations may result in the termination of KCSM’s Concession or in fines or penalties that may affect profitability.
Liabilities accrued for environmental costs represent the Company’s best estimate of the probable future obligation for the remediation and settlement of matters related to these sites. However, remediation costs may exceed such estimates, due to various factors such as evolving environmental laws and regulations, changes in technology, the extent of other parties’ participation, developments in environmental surveys and studies, and the extent of corrective action that may ultimately be required. The Company cannot predict the effect, if any, that unidentified environmental matters or the adoption of additional or more stringent environmental laws and regulations would have on KCS’s consolidated financial statements.
KCS’s failure or inability to comply with applicable environmental laws and regulations could have a material adverse effect on the Company’s consolidated financial statements and operations, including fines, penalties, or limitations on operating activities until compliance with applicable requirements is achieved. Government entities may change the legislative or regulatory framework within which the Company operates without providing any recourse for any adverse effects on the Company’s business that occur as a result of such change. Additionally, some of the regulations require KCS to obtain and maintain various licenses, permits and other authorizations. Any failure to obtain or maintain these licenses, permits, and other authorizations could have a material adverse effect on KCS’s business operations.
KCS’s business is vulnerable to fluctuations in fuel costs and disruptions in fuel supplies.
KCS incurs substantial fuel costs in its railroad operations and these costs represent a significant portion of its transportation expenses. Significant price increases for fuel may have a material adverse effect on operating results. If KCS is unable to recapture its costs of fuel from its customers, operating results could be materially adversely affected. In addition, a severe disruption of fuel supplies resulting from supply shortages, political unrest, a disruption of oil imports, weather events, war, or otherwise, and the resulting impact on fuel prices could have a material adverse effect on KCS’s consolidated financial statements.
KCSM currently meets the majority of its fuel requirements through purchases from PEMEX Transformación Industrial (“PEMEX”), a national oil company in Mexico, and other authorized fuel distributors of PEMEX fuel around the country. If PEMEX were to experience significant operational difficulties not quickly resolved, the KCSM operations could be materially adversely affected.
Weaknesses in the short and long-term debt markets could negatively impact the Company’s access to capital.
Due to the significant capital expenditures required to operate and maintain a safe and efficient railroad, the Company regularly obtains financing through the issuance of long-term debt instruments and short-term commercial paper, as well as credit facilities provided by financial institutions. Instability or disruptions of the capital markets, including debt markets, or the deterioration of the Company’s financial condition due to internal or external factors, could restrict or prohibit access and could increase the cost of financing sources. A significant deterioration of the Company’s financial condition could also reduce credit
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ratings to below investment grade, limiting its access to external sources of capital, and increasing the costs of short and long-term debt financing, and could have a material adverse effect on KCS’s consolidated financial statements.
KCS’s business may be affected by climate change and the market and regulatory responses to climate change.
Climate change could have a material adverse effect on operations and KCS’s consolidated financial statements. Restrictions, caps, taxes, or other controls on emissions of greenhouse gases, including diesel exhaust, could significantly impact operations and increase operating costs. Restrictions on emissions could also affect KCS’s customers that use commodities that KCS transports to produce energy, use significant amounts of energy in producing or delivering the commodities KCS transports, or manufacture or produce goods that consume significant amounts of energy or burn fossil fuels, including coal-fired power plants, chemical producers, farmers and food producers, and automakers and other manufacturers. Significant cost increases, government regulation, or changes of consumer preferences for goods or services relating to alternative sources of energy or emissions reductions could materially affect the markets for the commodities KCS transports, which in turn could have a material adverse effect on KCS’s consolidated financial statements. Government incentives encouraging the use of alternative sources of energy could also affect certain customers and their respective markets for certain commodities KCS transports in an unpredictable manner that could alter traffic patterns, including, for example, the impacts of ethanol incentives on farming and ethanol producers. Any of these factors, individually or in conjunction with one or more of the other factors, or other unforeseen impacts of climate change could have a material adverse effect on KCS’s consolidated financial statements.
A majority of KCS’s employees belong to labor unions. Strikes or work stoppages could adversely affect operations.
The Company is a party to collective bargaining agreements with various labor unions in the United States and Mexico. As of December 31, 2018, approximately 75% and 80% of KCSR and KCSM Servicios employees, respectively, were covered by labor contracts subject to collective bargaining. The Company may be subject to, among other things, strikes, work stoppages or work slowdowns as a result of disputes under these collective bargaining agreements and labor contracts or KCS’s potential inability to negotiate acceptable contracts with these unions. In the United States, because such agreements are generally negotiated on an industry-wide basis, determination of the terms and conditions of labor agreements have been and could continue to be beyond KCS’s control. KCS may, therefore, be subject to terms and conditions in industry-wide labor agreements that could have a material adverse effect on its consolidated financial statements. If the unionized workers in the United States or Mexico were to engage in a strike, work stoppage or other slowdown; if other employees were to become unionized or if the terms and conditions in future labor agreements were renegotiated, KCS could experience a significant disruption of its operations and higher ongoing labor costs. Although the U.S. Railway Labor Act imposes restrictions on the right of United States railway workers to strike, there is no law in Mexico imposing similar restrictions on the right of railway workers in that country to strike.
KCS is dependent on certain key suppliers of core rail equipment.
KCS relies on a limited number of suppliers of core rail equipment (including locomotives, rolling stock equipment, rail and ties). The capital intensive nature and complexity of such equipment creates high barriers of entry for any potential new suppliers. If any of KCS’s suppliers discontinue production or experience capacity or supply shortages, this could result in increased costs or difficulty in obtaining rail equipment and materials, which could have a material adverse effect on KCS’s consolidated financial statements.
The unavailability of qualified personnel could adversely affect KCS’s operations.
Changes in demographics, training requirements and the unavailability of qualified personnel could negatively affect KCS’s ability to meet demand for rail service. Unforeseen increases in demand for rail services may exacerbate such risks, which could have a negative impact on KCS’s operational efficiency and otherwise have a material adverse effect on KCS’s consolidated financial statements.
KCS’s business may be affected by future acts of terrorism, war or other acts of violence or crime.
Terrorist attacks, such as an attack on the Company’s chemical transportation activities, any government response thereto and war or risk of war could have a material adverse effect on KCS’s consolidated financial statements. These acts may also impact the Company’s ability to raise capital or its future business opportunities. KCS’s rail lines and facilities could be direct targets or indirect casualties of acts of terror, which could cause significant business interruption and damage to KCS’s
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property. In recent years, there have been reported incidents of train-related robberies in Mexico, including incidents involving KCSM’s trains and infrastructure. Other acts of violence or crime could also materially adversely affect the Company’s business.
As a result, acts of terrorism or war or acts of crime or violence could result in increased costs and liabilities and decreased revenues for KCS. In addition, insurance premiums charged for some or all of the applicable coverage currently maintained by KCS could increase dramatically or certain coverage may not be adequate to cover losses or may not be available in the future.
Item 1B. | Unresolved Staff Comments |
None.
Item 2. | Properties |
Track Configuration
The Kansas City Southern Railway Company (“KCSR”) operates over a railroad system consisting of approximately 3,400 route miles in ten states extending from the midwest and southeast portions of the United States south to the Mexican border, which includes approximately 640 miles of trackage rights that permit KCSR to operate its trains with its crews over other railroads’ tracks.
Under its concession from the Mexican government (the “Concession”), Kansas City Southern de México, S.A. de C.V. (“KCSM”) has the right to operate approximately 3,300 route miles, but does not own the land, roadway, or associated structures, and additionally has approximately 550 miles of trackage rights. The Concession requires KCSM to make investments as described in a business plan filed every three years with the Mexican government. See Item 1A, Risk Factors — “KCSM’s Mexican Concession is subject to revocation or termination in certain circumstances which would prevent KCSM from operating its railroad and would have a material adverse effect on the Company’s consolidated financial statements.”
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Kansas City Southern Rail Network
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Equipment Configuration
As of December 31, 2018 and 2017, KCS owned and leased the following units of equipment:
2018 | 2017 | ||||||||||||||||
Owned | Leased | Total | Owned | Leased | Total | ||||||||||||
Freight Cars: | |||||||||||||||||
Box cars | 3,178 | 991 | 4,169 | 3,205 | 1,212 | 4,417 | |||||||||||
Hoppers (covered and open top) | 5,419 | 1,108 | 6,527 | 4,735 | 2,107 | 6,842 | |||||||||||
Gondolas | 2,560 | 169 | 2,729 | 2,619 | 1,267 | 3,886 | |||||||||||
Automotive | 3,316 | 742 | 4,058 | 2,731 | 1,142 | 3,873 | |||||||||||
Flat cars (intermodal and other) | 1,142 | 1,075 | 2,217 | 850 | 98 | 948 | |||||||||||
Tank cars | 4 | 570 | 574 | 4 | 568 | 572 | |||||||||||
Total | 15,619 | 4,655 | 20,274 | 14,144 | 6,394 | 20,538 | |||||||||||
Locomotives: | |||||||||||||||||
Freight | 753 | 119 | 872 | 736 | 146 | 882 | |||||||||||
Switching | 177 | — | 177 | 187 | — | 187 | |||||||||||
Total | 930 | 119 | 1,049 | 923 | 146 | 1,069 | |||||||||||
Average Age (in Years) of Owned and Leased Locomotives: | 2018 | 2017 | |||
Freight | 16.9 | 16.2 | |||
Switching | 43.5 | 42.0 | |||
All locomotives | 21.5 | 20.2 | |||
Property and Facilities
KCS operates numerous facilities, including terminals for intermodal and other freight, rail yards for train-building, switching, storage-in-transit (the temporary storage of customer goods in rail cars prior to shipment) and other activities; offices to administer and manage operations; dispatch centers to direct traffic on the rail network; crew quarters to house train crews along the rail line; and shops and other facilities for fueling and maintenance and repair of locomotives, freight cars and other equipment.
Capital Expenditures
The Company’s cash capital expenditures for the three years ended December 31, 2018, 2017, and 2016, and planned 2019 capital expenditures are included in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources — Capital Expenditures. See also Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates — Capitalization, Depreciation and Amortization of Property and Equipment (including Concession Assets) regarding the Company’s policies and guidelines related to capital expenditures.
Item 3. | Legal Proceedings |
The Company is subject to various legal proceedings and claims that arise in the ordinary course of business. For more information on legal proceedings, see Item 1A, Risk Factors — “KCS may be subject to various claims and litigation that could have a material adverse effect on KCS’s consolidated financial statements,” Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations — Other Matters — Litigation, and Item 8, Financial Statements and Supplementary Data — Note 16, Commitments and Contingencies.
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Item 4. | Mine Safety Disclosures |
Not applicable.
Part II
Item 5. | Market for KCS’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities |
Market Information
The Company’s common stock is traded on the New York Stock Exchange under the ticker symbol “KSU”. The following table presents for the quarters indicated the dividends declared for the Company’s common and preferred stock.
Fourth | Third | Second | First | ||||||||||||
2018 | |||||||||||||||
Dividends per share: | |||||||||||||||
Common stock | $ | 0.36 | $ | 0.36 | $ | 0.36 | $ | 0.36 | |||||||
$25 par preferred stock | 0.25 | 0.25 | 0.25 | 0.25 | |||||||||||
2017 | |||||||||||||||
Dividends per share: | |||||||||||||||
Common stock | $ | 0.36 | $ | 0.36 | $ | 0.33 | $ | 0.33 | |||||||
$25 par preferred stock | 0.25 | 0.25 | 0.25 | 0.25 | |||||||||||
Dividend Policy
Common Stock. Any declarations and payments of dividends to holders of the Company’s common stock are at the discretion of the Board of Directors, and are based on many factors, including the Company’s financial condition, earnings, capital requirements and other factors that the Board of Directors deems relevant. Subject to these qualifications, the Company expects to continue to pay dividends on an ongoing basis.
Holders
There were 2,063 record holders of KCS common stock on January 18, 2019; however, the number of actual holders of KCS common stock is greater due to the practice of brokerage firms registering many shares for clients in the brokerage firm’s name.
Securities Authorized for Issuance Under Equity Compensation Plans
See Item 12, Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters for information about securities authorized for issuance under KCS’s equity compensation plans.
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Performance Graph
The following graph shows the changes in value over the five years ended December 31, 2018, of an assumed investment of $100 in: (i) KCS’s common stock; (ii) the stocks that comprise the Dow Jones U.S. Industrial Transportation Index; and (iii) the stocks that comprise the S&P 500 Index. The table following the graph shows the value of those investments on December 31 for each of the years indicated. The values for the assumed investments depicted on the graph and in the table have been calculated assuming that any cash dividends are reinvested.
COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN
Among Kansas City Southern, the S&P 500 Index
and the Dow Jones U.S. Industrial Transportation Index
2013 | 2014 | 2015 | 2016 | 2017 | 2018 | |||||||||||||
Kansas City Southern | $ | 100.00 | $ | 99.55 | $ | 61.80 | $ | 71.28 | $ | 89.63 | $ | 82.40 | ||||||
S&P 500 (1) | 100.00 | 113.69 | 115.26 | 129.05 | 157.22 | 150.33 | ||||||||||||
Dow Jones U.S. Industrial Transportation (2) | 100.00 | 121.68 | 94.72 | 122.67 | 157.31 | 144.98 | ||||||||||||
_____________________
(1) | The S&P 500 is a registered trademark of Standard & Poor’s, a division of S&P Global, Inc. The S&P 500 Index reflects the weighted average market value for 500 companies whose shares are traded on the New York Stock Exchange, American Stock Exchange and the Nasdaq Stock Market. |
(2) | The Dow Jones U.S. Industrial Transportation Index is a registered trademark of S&P Dow Jones Indices LLC, a division of S&P Global, Inc. |
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Purchases of Equity Securities
During 2018, KCS repurchased 2,272,213 shares of common stock for $243.1 million at an average price of $106.98 per share and 13,775 shares of $25 par preferred stock for $0.4 million at an average price of $26.23 per share. See Item 8, Financial Statements and Supplementary Data — Note 14, Stockholders’ Equity for additional information.
The following table presents stock repurchases during each month for the fourth quarter of 2018:
Period | (a) Total Number of Shares (or Units) Purchased (1) | (b) Average Price Paid per Share (or Unit) | (c) Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs (2) | (d) Maximum Number (or Approximate Dollar Value) of Shares (or Units) that may yet be purchased under the Plans or Programs (2) | |||||||||||||||
Common stock | |||||||||||||||||||
October 1-31, 2018 | 100,909 | $ | 102.00 | 100,909 | $ | 371,439,510 | |||||||||||||
November 1-30, 2018 | 345,341 | $ | 100.58 | 345,341 | $ | 336,705,382 | |||||||||||||
December 1-31, 2018 | 350,757 | $ | 99.71 | 350,757 | $ | 301,732,864 | |||||||||||||
Total | 797,007 | 797,007 | |||||||||||||||||
$25 Par preferred stock | |||||||||||||||||||
October 1-31, 2018 | 900 | $ | 26.53 | — | — | ||||||||||||||
November 1-30, 2018 | 2,500 | $ | 26.58 | — | — | ||||||||||||||
December 1-31, 2018 | 1,150 | $ | 26.15 | — | — | ||||||||||||||
Total | 4,550 | — | |||||||||||||||||
(1 | ) | All $25 par preferred stock repurchases were made other than through a publicly disclosed plan or program. Repurchases of $25 par preferred stock were made through open market purchases and/or privately negotiated transactions. |
(2 | ) | On August 15, 2017, the Company announced that the Board of Directors approved a share repurchase program, pursuant to which up to $800.0 million in shares of common stock could be repurchased through June 30, 2020. The authorization included a $200.0 million Accelerated Share Repurchase (“ASR”) program and a $600.0 million open market share repurchase program. |
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Item 6. | Selected Financial Data |
The selected financial data below (in millions, except per share amounts) should be read in conjunction with Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations as well as the consolidated financial statements and the related notes.
2018 | 2017 | 2016 | 2015 | 2014 | |||||||||||||||
Earnings From Continuing Operations | |||||||||||||||||||
Revenues | $ | 2,714.0 | $ | 2,582.9 | $ | 2,334.2 | $ | 2,418.8 | $ | 2,577.1 | |||||||||
Operating expenses (i) (ii) (iii) | 1,727.7 | 1,661.3 | 1,515.7 | 1,615.0 | 1,768.0 | ||||||||||||||
Operating income | $ | 986.3 | $ | 921.6 | $ | 818.5 | $ | 803.8 | $ | 809.1 | |||||||||
Net income (iv) (v) | $ | 629.4 | $ | 963.9 | $ | 479.9 | $ | 485.3 | $ | 504.3 | |||||||||
Earnings per common share: | |||||||||||||||||||
Basic | $ | 6.16 | $ | 9.18 | $ | 4.44 | $ | 4.41 | $ | 4.56 | |||||||||
Diluted | 6.13 | 9.16 | 4.43 | 4.40 | 4.55 | ||||||||||||||
Financial Position | |||||||||||||||||||
Total assets | $ | 9,469.8 | $ | 9,198.7 | $ | 8,817.5 | $ | 8,341.0 | $ | 7,976.4 | |||||||||
Total long-term debt obligations, including current portion and short-term borrowings | 2,689.4 | 2,619.4 | 2,478.2 | 2,401.1 | 2,301.4 | ||||||||||||||
Total stockholders’ equity | 4,813.0 | 4,548.9 | 4,089.9 | 3,914.3 | 3,755.5 | ||||||||||||||
Total equity | 5,132.7 | 4,865.4 | 4,404.5 | 4,224.7 | 4,064.1 | ||||||||||||||
Other Data Per Common Share | |||||||||||||||||||
Cash dividends declared per common share | $ | 1.44 | $ | 1.38 | $ | 1.32 | $ | 1.32 | $ | 1.12 | |||||||||
_____________________
(i) | During 2018, the Company recognized a pre-tax gain of $17.9 million within operating expenses for insurance recoveries related to damage from Hurricane Harvey in 2017. |
(ii) | During 2018, 2017 and 2016, the Company recognized a benefit of $37.7 million, $44.1 million and $62.8 million respectively, within operating expenses related to a credit available for the excise tax included in the price of fuel that is purchased and consumed in locomotives and certain work equipment in Mexico. |
(iii) | During 2015 and 2014, the Company recognized pre-tax lease termination costs of $9.6 million and $38.3 million, respectively, within operating expenses due to the early termination of certain operating leases and the related purchase of equipment. |
(iv) | During 2018, 2015 and 2014, the Company recognized pre-tax debt retirement and exchange costs of $2.2 million, $7.6 million and $6.6 million, respectively, related to debt retirement and restructuring activities that occurred during the periods. |
(v) | During 2017, the Company recognized a provisional $413.0 million net tax benefit, as a result of the Tax Cuts and Jobs Act (the “Tax Reform Act”), which was signed into law December 22, 2017. During 2018, the Company recognized a $20.9 million net tax benefit for adjustments to the provisional tax impacts of the Tax Reform Act recognized in 2017. |
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Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following is a discussion of Kansas City Southern’s results of operations, certain changes in its financial position, liquidity, capital structure and business developments for the periods covered by the consolidated financial statements included under Item 8 of this Form 10-K. This discussion should be read in conjunction with the included consolidated financial statements, the related notes, and other information included in this report.
CAUTIONARY INFORMATION
The discussions set forth in this Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, management may make forward-looking statements orally or in other writings, including, but not limited to, in press releases, quarterly earnings calls, executive presentations, in the annual report to stockholders and in other filings with the Securities and Exchange Commission. Readers can usually identify these forward-looking statements by the use of such verbs as “expects,” “anticipates,” “believes” or similar verbs or conjugations of such verbs. These statements involve a number of risks and uncertainties. Actual results could materially differ from those anticipated by such forward-looking statements. Such differences could be caused by a number of factors or combination of factors including, but not limited to, the factors identified below and those discussed under Item 1A, Risk Factors, of this Form 10-K. Readers are strongly encouraged to consider these factors and the following factors when evaluating any forward-looking statements concerning the Company:
• | the outcome of claims and litigation, including those related to environmental contamination, personal injuries and property damage; |
• | changes in legislation and regulations or revisions of controlling authority; |
• | the adverse impact of any termination or revocation of Kansas City Southern de México, S.A. de C.V. (“KCSM”)’s concession by the Mexican government; |
• | United States, Mexican and global economic, political and social conditions; |
• | the effects of current and future multinational trade agreements on the level of trade among the United States, Mexico and Canada; |
• | the level of trade between the United States and Asia or Mexico; |
• | the effects of fluctuations in the peso-dollar exchange rate; |
• | natural events such as severe weather, fire, floods, hurricanes, earthquakes or other disruptions to the Company’s operating systems, structures and equipment or the ability of customers to produce or deliver their products; |
• | the effects of adverse general economic conditions affecting customer demand and the industries and geographic areas that produce and consume the commodities KCS carries; |
• | the dependence on the stability, availability and security of the information technology systems to operate its business; |
• | the effect of demand for KCS’s services exceeding network capacity or traffic congestion on operating efficiencies and service reliability; |
• | uncertainties regarding the litigation KCS faces and any future claims and litigation; |
• | the impact of competition, including competition from other rail carriers, trucking companies and maritime shippers in the United States and Mexico; |
• | KCS’s reliance on agreements with other railroads and third parties to successfully implement its business strategy, operations and growth and expansion plans, including the strategy to convert customers from using trucking services to rail transportation services; |
• | compliance with environmental regulations; |
• | disruption in fuel supplies, changes in fuel prices and the Company’s ability to recapture its costs of fuel from customers; |
• | material adverse changes in economic and industry conditions, including the availability of short and long-term financing, both within the United States and Mexico and globally; |
• | climate change and the market and regulatory responses to climate change; |
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• | changes in labor costs and labor difficulties, including strikes and work stoppages affecting either operations or customers’ abilities to deliver goods for shipment; |
• | KCS’s reliance on certain key suppliers of core rail equipment; |
• | unavailability of qualified personnel; and |
• | acts of terrorism, war or other acts of violence or crime or risk of such activities. |
Forward-looking statements reflect the information only as of the date on which they are made. The Company does not undertake any obligation to update any forward-looking statements to reflect future events, developments, or other information. If KCS does update one or more forward-looking statements, no inference should be drawn that additional updates will be made regarding that statement or any other forward-looking statements.
CORPORATE OVERVIEW
Kansas City Southern, a Delaware corporation, is a transportation holding company that has railroad investments in the U.S., Mexico and Panama. In the U.S., the Company serves the central and south central U.S. Its international holdings serve northeastern and central Mexico and the port cities of Lazaro Cardenas, Tampico and Veracruz, and a fifty percent interest in Panama Canal Railway Company provides ocean-to-ocean freight and passenger service along the Panama Canal. KCS’s North American rail holdings and strategic alliances are primary components of a North American Free Trade Agreement (“NAFTA”) railway system, linking the commercial and industrial centers of the U.S., Canada and Mexico. Its principal subsidiaries and affiliates include the following:
• | The Kansas City Southern Railway Company (“KCSR”), a wholly-owned subsidiary; |
• | KCSM, a wholly-owned subsidiary; |
• | Mexrail, Inc. (“Mexrail”), a wholly-owned consolidated subsidiary; which, in turn, wholly owns The Texas Mexican Railway Company (“Tex-Mex”); |
• | KCSM Servicios, S.A. de C.V. (“KCSM Servicios”), a wholly-owned subsidiary; |
• | Meridian Speedway, LLC (“MSLLC”), a seventy percent-owned consolidated affiliate; |
• | Panama Canal Railway Company (“PCRC”), a fifty percent-owned unconsolidated affiliate; |
• | TFCM, S. de R.L. de C.V. (“TCM”), a forty-five percent-owned unconsolidated affiliate; |
• | Ferrocarril y Terminal del Valle de México, S.A. de C.V. (“FTVM”), a twenty-five percent-owned unconsolidated affiliate; and |
• | PTC-220, LLC (“PTC-220”), a fourteen percent-owned unconsolidated affiliate. |
EXECUTIVE SUMMARY
2018 Financial Overview
Revenues in 2018 increased 5% from 2017, due to 3% and 2% increases in revenue per carload/unit and carload/unit volumes, respectively. Revenue per carload/unit increased due to higher fuel surcharge and positive pricing impacts, partially offset by the weakening of the Mexican peso against the U.S. dollar. Volumes increased primarily due to increased refined product shipments to Mexico, crude oil growth as a result of increased production in Canada, higher intermodal volumes, and favorable comparative volumes due to Hurricane Harvey service interruptions in 2017. These increases were partially offset by a decline in Energy driven primarily by a reduction in utility coal volume due to a Texas utility closure in January 2018, and network congestion in northern Mexico during the second half of 2018. During the second half of the fourth quarter of 2018, network fluidity improved from the peak congestion that occurred in the third quarter of 2018.
Operating expenses increased 4% compared to 2017, primarily due to higher fuel prices, increases in depreciation and personal injury expense, and an increase in expenses due to network congestion in northern Mexico. These increases were partially offset by gain on insurance recoveries related to hurricane damage and the weakening of the Mexican peso against the U.S. dollar. Expense fluctuations resulting from higher fuel prices and the weakening of the Mexican peso partially offset the revenue fluctuations driven by these same macroeconomic factors. Operating expenses as a percentage of revenues decreased to 63.7% in 2018 from 64.3% in 2017.
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In 2018, the Company invested $512.3 million in capital expenditures. In addition, the Company purchased $100.5 million of equipment under existing operating leases or replacement equipment as certain operating leases expired, which was primarily funded with internally generated cash flows and debt.
The Company reported 2018 earnings of $6.13 per diluted share on consolidated net income attributable to Kansas City Southern and subsidiaries of $627.4 million for the year ended December 31, 2018, compared to annual earnings of $9.16 per diluted share on consolidated net income attributable to Kansas City Southern and subsidiaries of $962.0 million for 2017. The decrease is due to a higher effective tax rate in 2018 primarily as a result of the $413.0 million net tax benefit recognized in 2017 resulting from the Tax Cuts and Jobs Act (the “Tax Reform Act”), and lower foreign exchange gain, partially offset by an increase in operating income.
RESULTS OF OPERATIONS
Year Ended December 31, 2018, compared with the Year Ended December 31, 2017
The following summarizes KCS’s consolidated income statement components (in millions):
2018 | 2017 | Change | |||||||||
Revenues | $ | 2,714.0 | $ | 2,582.9 | $ | 131.1 | |||||
Operating expenses | 1,727.7 | 1,661.3 | 66.4 | ||||||||
Operating income | 986.3 | 921.6 | 64.7 | ||||||||
Equity in net earnings of affiliates | 2.6 | 11.5 | (8.9 | ) | |||||||
Interest expense | (110.0 | ) | (100.2 | ) | (9.8 | ) | |||||
Debt retirement costs | (2.2 | ) | — | (2.2 | ) | ||||||
Foreign exchange gain | 7.8 | 41.7 | (33.9 | ) | |||||||
Other income (expense), net | 2.4 | (0.3 | ) | 2.7 | |||||||
Income before income taxes | 886.9 | 874.3 | 12.6 | ||||||||
Income tax expense (benefit) | 257.5 | (89.6 | ) | 347.1 | |||||||
Net income | 629.4 | 963.9 | (334.5 | ) | |||||||
Less: Net income attributable to noncontrolling interest | 2.0 | 1.9 | 0.1 | ||||||||
Net income attributable to Kansas City Southern and subsidiaries | $ | 627.4 | $ | 962.0 | $ | (334.6 | ) | ||||
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Revenues
The following summarizes revenues (in millions), carload/unit statistics (in thousands) and revenue per carload/unit:
Revenues | Carloads and Units | Revenue per Carload/Unit | ||||||||||||||||||||||||||||
2018 | 2017 | % Change | 2018 | 2017 | % Change | 2018 | 2017 | % Change | ||||||||||||||||||||||
Chemical and petroleum | $ | 622.1 | $ | 539.9 | 15 | % | 297.9 | 273.5 | 9 | % | $ | 2,088 | $ | 1,974 | 6 | % | ||||||||||||||
Industrial and consumer products | 591.0 | 588.3 | — | 324.9 | 329.9 | (2 | %) | 1,819 | 1,783 | 2 | % | |||||||||||||||||||
Agriculture and minerals | 486.4 | 477.4 | 2 | % | 241.9 | 244.3 | (1 | %) | 2,011 | 1,954 | 3 | % | ||||||||||||||||||
Energy | 256.3 | 283.8 | (10 | %) | 248.6 | 291.7 | (15 | %) | 1,031 | 973 | 6 | % | ||||||||||||||||||
Intermodal | 382.8 | 363.8 | 5 | % | 1,030.4 | 975.1 | 6 | % | 372 | 373 | — | |||||||||||||||||||
Automotive | 253.2 | 230.8 | 10 | % | 161.9 | 155.5 | 4 | % | 1,564 | 1,484 | 5 | % | ||||||||||||||||||
Carload revenues, carloads and units | 2,591.8 | 2,484.0 | 4 | % | 2,305.6 | 2,270.0 | 2 | % | $ | 1,124 | $ | 1,094 | 3 | % | ||||||||||||||||
Other revenue | 122.2 | 98.9 | 24 | % | ||||||||||||||||||||||||||
Total revenues (i) | $ | 2,714.0 | $ | 2,582.9 | 5 | % | ||||||||||||||||||||||||
(i) Included in revenues: | ||||||||||||||||||||||||||||||
Fuel surcharge | $ | 253.1 | $ | 169.5 | ||||||||||||||||||||||||||
Revenues include revenue for transportation services and fuel surcharges. Revenues and carload/unit volumes increased 5% and 2%, respectively, for the year ended December 31, 2018, compared to the prior year. Volumes increased primarily due to increased refined product shipments to Mexico, crude oil growth as a result of increased production in Canada, higher intermodal volumes, and favorable comparative volumes due to Hurricane Harvey service interruptions in 2017. These increases were partially offset by a decline in Energy driven primarily by a reduction in utility coal volume due to a Texas utility closure in January 2018, and network congestion in northern Mexico during the second half of 2018.
Revenue per carload/unit increased by 3% due to higher fuel surcharge and positive pricing impacts. The increase in revenue per carload/unit was partially offset by the weakening of the Mexican peso against the U.S. dollar of approximately $9.0 million, compared to the prior year, for revenue transactions denominated in Mexican pesos. The average exchange rate of Mexican pesos per U.S. dollar was Ps.19.2 for 2018 compared to Ps.18.9 for 2017.
KCS’s fuel surcharges are a mechanism to adjust revenue based upon changes in fuel prices above fuel price thresholds set in KCS’s tariffs or contracts. Fuel surcharge revenue is calculated using a fuel price from a prior time period that can be up to 60 days earlier. In a period of volatile fuel prices or changing customer business mix, changes in fuel expense and fuel surcharge revenue may differ.
Fuel surcharge revenue increased $83.6 million for the year ended December 31, 2018, compared to the prior year, primarily due to higher fuel prices and increased fuel surcharge rates.
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The following discussion provides an analysis of revenues by commodity group:
Revenues by commodity
group for 2018
Chemical and petroleum. Revenues increased $82.2 million for the year ended December 31, 2018, compared to 2017, due to a 9% increase in carload/unit volumes and a 6% increase in revenue per carload/unit. Volumes increased primarily due to increased refined fuel product shipments to Mexico and favorable comparative volumes due to Hurricane Harvey service interruptions in 2017. Revenue per carload/unit increased due to longer average length of haul, higher fuel surcharge, and positive pricing impacts. |  |
Industrial and consumer products. Revenue increased $2.7 million for the year ended December 31, 2018, compared to 2017, due to a 2% increase in revenue per carload/unit offset by a 2% decrease in carload/unit volumes. Revenue per carload/unit increased due to higher fuel surcharge, mix, and positive pricing impacts, partially offset by shorter average length of haul due to change in sourcing location for a metals plant. Volumes decreased due to capacity constraints and network congestion in northern Mexico, partially offset by favorable comparative volumes due to Hurricane Harvey service interruptions in 2017. |  |
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Revenues by commodity
group for 2018
Agriculture and minerals. Revenues increased $9.0 million for the year ended December 31, 2018 compared to 2017, due to a 3% increase in revenue per carload/unit, partially offset by a 1% decrease in carload/unit volumes. Revenue per carload/unit increased due to higher fuel surcharge, longer average length of haul, and positive pricing impacts. Volume decreased due to network congestion in northern Mexico and changes in food products due to lower market demand, a facility outage, and shift in sourcing trends. |  |
Energy. Revenues decreased $27.5 million for the year ended December 31, 2018, compared to 2017, due to a 15% decrease in carload/unit volumes, partially offset by a 6% increase in revenue per carload/unit. Utility coal volumes decreased due to a Texas utility closure in January 2018 and lower natural gas prices. Frac sand volumes decreased due to changes in sourcing patterns. These decreases were partially offset by crude oil growth driven by increased production in Canada with increased rail utilization. Revenue per carload/unit increased due to mix, higher fuel surcharge, and positive pricing impacts, partially offset by a shorter average length of haul. |  |
Intermodal. Revenues increased $19.0 million for the year ended December 31, 2018, compared to 2017, due to a 6% increase in carload/unit volumes attributable to growth in the U.S. domestic and cross-border lanes, which was aided by tight truck capacity, and favorable comparative volumes due to Hurricane Harvey service interruptions in 2017. This was partially offset by lower international volumes as a result of lost business to truck competition and competitive rail pricing due to the weakness of the Mexican peso against the U.S. dollar.
Automotive. Revenues increased $22.4 million for the year ended December 31, 2018, compared to 2017, due to 5% increase in revenue per carload/unit and a 4% increase in carload/unit volumes. Revenue per carload/unit increased due to higher fuel surcharge and positive pricing impacts, partially offset by a shorter average length of haul and the weakening of the Mexican peso against the U.S. dollar. Volumes increased due to an increase in plant production and an increase in Lazaro Cardenas import volumes, partially offset by network congestion in northern Mexico.
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Operating Expenses
Operating expenses, as shown below (in millions), increased $66.4 million for the year ended December 31, 2018, compared to 2017, primarily due to higher fuel prices, increases in depreciation and personal injury expense, and an increase in expenses due to network congestion in northern Mexico during the second half of 2018. These increases were partially offset by a gain on insurance recoveries related to hurricane damage and the weakening of the Mexican peso against the U.S. dollar. The weakening of the Mexican peso against the U.S. dollar resulted in an expense reduction of approximately $9.0 million for expense transactions denominated in Mexican pesos. The average exchange rate of Mexican pesos per U.S. dollar was Ps.19.2 for 2018 compared to Ps.18.9 for 2017.
Change | ||||||||||||||
2018 | 2017 | Dollars | Percent | |||||||||||
Compensation and benefits | $ | 495.7 | $ | 493.8 | $ | 1.9 | — | |||||||
Purchased services | 200.7 | 193.7 | 7.0 | 4 | % | |||||||||
Fuel | 348.2 | 316.1 | 32.1 | 10 | % | |||||||||
Mexican fuel excise tax credit | (37.7 | ) | (44.1 | ) | 6.4 | (15 | %) | |||||||
Equipment costs | 126.1 | 129.2 | (3.1 | ) | (2 | %) | ||||||||
Depreciation and amortization | 346.7 | 320.9 | 25.8 | 8 | % | |||||||||
Materials and other | 265.9 | 251.7 | 14.2 | 6 | % | |||||||||
Gain on insurance recoveries related to hurricane damage | (17.9 | ) | — | (17.9 | ) | 100 | % | |||||||
Total operating expenses | $ | 1,727.7 | $ | 1,661.3 | $ | 66.4 | 4 | % | ||||||
Compensation and benefits. Compensation and benefits increased $1.9 million for the year ended December 31, 2018, compared to 2017, due to wage inflation of approximately $15.0 million and increased headcount of approximately $12.0 million, partially offset by a decrease in incentive compensation of approximately $14.0 million, reduced benefits of approximately $8.0 million, and the weakening of the Mexican peso of approximately $3.0 million.
Purchased services. Purchased services expense increased $7.0 million for the year ended December 31, 2018, compared to 2017, due to higher repairs and maintenance expense and increases in computer software and programming expenses, partially offset by savings from mechanical in-sourcing starting in the fourth quarter of 2017.
Fuel. Fuel expense increased $32.1 million for the year ended December 31, 2018, compared to 2017, due to higher diesel fuel prices of approximately $27.0 million and $18.0 million in the U.S. and Mexico, respectively, partially offset by lower consumption of approximately $9.0 million and the weakening of the Mexican peso of approximately $4.0 million. The average price per gallon was $2.58 in 2018, compared to $2.27 in 2017.
Mexican fuel excise tax credit. For the year ended December 31, 2018, the Company recognized a $37.7 million benefit, compared to a $44.1 million benefit recognized in 2017. The reduced benefit is due to a lower excise tax rate in effect for 2018 as compared to 2017.
Equipment costs. Equipment costs decreased $3.1 million for the year ended December 31, 2018, compared to 2017, due to lower lease expense, partially offset by higher car hire expense resulting from network congestion in northern Mexico.
Depreciation and amortization. Depreciation and amortization expense increased $25.8 million for the year ended December 31, 2018, compared to 2017, due to a larger asset base, including investments in positive train control.
Materials and other. Materials and other expense increased $14.2 million for the year ended December 31, 2018, compared to 2017, due to an increase in personal injury expense of approximately $2.0 million recognized in 2018, compared to an approximate $4.0 million reduction in personal injury expense recognized in 2017 as a result of changes in estimates. Additional increased expense was due to higher derailment activity of approximately $6.0 million, and mechanical in-sourcing, which resulted in additional materials purchased of approximately $3.0 million.
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Gain on insurance recoveries related to hurricane damage. During 2018, the Company partially settled its insurance claim for $35.5 million related to Hurricane Harvey. As a result of the nonrefundable partial settlement, the Company recognized a gain on insurance recoveries of $17.9 million, net of the self-insured retention and insurance receivable.
Non-Operating Expenses
Equity in net earnings of affiliates. Equity in net earnings from affiliates decreased $8.9 million for the year ended December 31, 2018, compared to 2017. Significant components of this change are as follows:
* Equity in earnings from the operations of FTVM decreased $5.4 million for the year ended December 31, 2018, compared to 2017, due to FTVM’s participation in constructing, maintaining, and operating a rail spur to Mexico City’s new international airport, in which the airport’s construction has been suspended.
* Equity in earnings from the operations of PCRC decreased $3.1 million for the year ended December 31, 2018, compared to 2017 as a result of lower volumes primarily due to loss of a customer.
Interest expense. Interest expense increased $9.8 million for the year ended December 31, 2018, compared to 2017, due to higher average interest rates and debt balances. For the year ended December 31, 2018, the average debt balance (including commercial paper) was $2,698.7 million, compared to $2,603.6 million in 2017. The average interest rate for the year ended December 31, 2018 was 4.1%, compared to 3.9% in 2017.
Debt retirement costs. Debt retirement costs were $2.2 million during 2018, related to the call premiums and write-off of unamortized debt issuance costs and original issue discounts associated with the Company’s various debt redemption activities. The Company did not incur debt retirement costs during 2017.
Foreign exchange gain. For the years ended December 31, 2018 and 2017, foreign exchange gain was $7.8 million and $41.7 million, respectively. Foreign exchange gain includes the re-measurement and settlement of net monetary assets denominated in Mexican pesos and the gain on foreign currency derivative contracts.
For the years ended December 31, 2018 and 2017, the re-measurement and settlement of net monetary assets denominated in Mexican pesos resulted in a foreign exchange gain of $1.5 million and $3.5 million, respectively.
The Company enters into foreign currency derivative contracts to hedge its net exposure to fluctuations in the Mexican cash tax obligation due to changes in the value of the Mexican peso against the U.S. dollar. For the years ended December 31, 2018 and 2017, foreign exchange gain on foreign currency derivative contracts was $6.3 million and $38.2 million, respectively.
Other income (expense), net. Other income (expense), net, increased $2.7 million for the year ended December 31, 2018, compared to 2017, due to an increase in miscellaneous income.
Income tax expense (benefit). Income tax expense increased $347.1 million for the year ended December 31, 2018, compared to 2017, due to the impact of the Tax Reform Act enacted on December 22, 2017. For the year ended December 31, 2017, the Company recognized a $487.6 million tax benefit as a result of revaluing the U.S. ending net deferred tax liabilities from 35% to the newly enacted U.S. corporate income tax rate of 21%. The tax benefit was partially offset by tax expense of $74.6 million for the deemed mandatory repatriation of undistributed earnings. The effective tax rate was 29.0% and (10.2%) for the years ended December 31, 2018 and 2017, respectively. The increase in the effective tax rate was due to the impact of the Tax Reform Act. The effective tax rate for the year ended December 31, 2018 reflects the benefit of the permanent reduction in the U.S. corporate income tax rate from a maximum of 35% to 21%, partially offset by an increase of 1.3% in the effective tax rate due to the impact of the global intangible low-taxed income (“GILTI”) provisions included in the Tax Reform Act and effective January 1, 2018. The Company also recognized a $20.9 million tax benefit during 2018, related to adjustments to the provisional tax impacts of the Tax Reform Act as provided for in Staff Accounting Bulletin No. 118 for the deemed repatriation earnings and the revaluation of deferred tax assets and liabilities included in its consolidated financial statements for the year ended December 31, 2017.
The fluctuations of the Mexican peso during 2018 decreased the Company’s Mexican cash tax obligation by $1.8 million for the year ended December 31, 2018, whereas the strengthening of the Mexican peso during 2017 increased the Company’s Mexican cash tax obligation by $18.8 million for the year ended December 31, 2017. The Company enters into foreign currency derivative contracts to hedge its net exposure to fluctuations in the Mexican cash tax obligation due to changes in the
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value of the Mexican peso against the U.S. dollar, and gains and losses on these foreign currency derivative contracts are recorded in foreign exchange gain (loss).
Mexico Tax Reform
In December 2018, the Mexican government enacted changes in the tax law effective January 1, 2019 (“Mexico Tax Reform”). Mexico Tax Reform eliminated “universal compensation” that allowed Mexican taxpayers to offset recoverable tax balances against balances due for other federal taxes. The elimination of “universal compensation” could negatively impact the timing of KCSM’s cash flow by up to $60.0 million in 2019 while awaiting refunds of value added tax from the Mexican government.
Mexico Tax Reform also eliminated the option to monetize the Mexican fuel excise tax credit by offsetting income tax withholding payment obligations. Previously, the Company had the option to monetize the Mexican fuel excise tax credit through income tax withholding and income tax obligations. The Company believes it will continue to be eligible for the Mexican fuel excise tax credit and will have the ability to offset future credits against income tax obligations in accordance with Mexico Tax Reform.
Mexico Tax Reform included tax incentives for a northern border zone of Mexico. The Company does not expect the northern border zone incentives will have a material impact to the Company’s consolidated financial statements.
The Company is continuing to evaluate the potential impact of Mexico Tax Reform to the 2019 consolidated financial statements.
Further information on the components of the effective tax rates for the years ended December 31, 2018 and 2017, is presented in Item 8, Financial Statements and Supplementary Data — Note 13, Income Taxes.
Year Ended December 31, 2017, compared with the Year Ended December 31, 2016
The following summarizes KCS’s consolidated income statement components (in millions):
2017 | 2016 | Change | |||||||||
Revenues | $ | 2,582.9 | $ | 2,334.2 | $ | 248.7 | |||||
Operating expenses | 1,661.3 | 1,515.7 | 145.6 | ||||||||
Operating income | 921.6 | 818.5 | 103.1 | ||||||||
Equity in net earnings of affiliates | 11.5 | 14.6 | (3.1 | ) | |||||||
Interest expense | (100.2 | ) | (97.7 | ) | (2.5 | ) | |||||
Foreign exchange gain (loss) | 41.7 | (72.0 | ) | 113.7 | |||||||
Other expense, net | (0.3 | ) | (0.7 | ) | 0.4 | ||||||
Income before income taxes | 874.3 | 662.7 | 211.6 | ||||||||
Income tax expense (benefit) | (89.6 | ) | 182.8 | (272.4 | ) | ||||||
Net income | 963.9 | 479.9 | 484.0 | ||||||||
Less: Net income attributable to noncontrolling interest | 1.9 | 1.8 | 0.1 | ||||||||
Net income attributable to Kansas City Southern and subsidiaries | $ | 962.0 | $ | 478.1 | $ | 483.9 | |||||
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Revenues
The following summarizes revenues (in millions), carload/unit statistics (in thousands) and revenue per carload/unit:
Revenues | Carloads and Units | Revenue per Carload/Unit | ||||||||||||||||||||||||||||
2017 | 2016 | % Change | 2017 | 2016 | % Change | 2017 | 2016 | % Change | ||||||||||||||||||||||
Chemical and petroleum | $ | 539.9 | $ | 475.4 | 14 | % | 273.5 | 258.5 | 6 | % | $ | 1,974 | $ | 1,839 | 7 | % | ||||||||||||||
Industrial and consumer products | 588.3 | 554.0 | 6 | % | 329.9 | 317.0 | 4 | % | 1,783 | 1,748 | 2 | % | ||||||||||||||||||
Agriculture and minerals | 477.4 | 461.0 | 4 | % | 244.3 | 251.4 | (3 | %) | 1,954 | 1,834 | 7 | % | ||||||||||||||||||
Energy | 283.8 | 202.7 | 40 | % | 291.7 | 253.9 | 15 | % | 973 | 798 | 22 | % | ||||||||||||||||||
Intermodal | 363.8 | 357.6 | 2 | % | 975.1 | 952.8 | 2 | % | 373 | 375 | (1 | %) | ||||||||||||||||||
Automotive | 230.8 | 189.9 | 22 | % | 155.5 | 133.3 | 17 | % | 1,484 | 1,425 | 4 | % | ||||||||||||||||||
Carload revenues, carloads and units | 2,484.0 | 2,240.6 | 11 | % | 2,270.0 | 2,166.9 | 5 | % | $ | 1,094 | $ | 1,034 | 6 | % | ||||||||||||||||
Other revenue | 98.9 | 93.6 | 6 | % | ||||||||||||||||||||||||||
Total revenues (i) | $ | 2,582.9 | $ | 2,334.2 | 11 | % | ||||||||||||||||||||||||
(i) Included in revenues: | ||||||||||||||||||||||||||||||
Fuel surcharge | $ | 169.5 | $ | 103.8 | ||||||||||||||||||||||||||
Revenues include both revenue for transportation services and fuel surcharges. Notwithstanding the impacts of Hurricane Harvey, revenues and carload/unit volumes increased 11% and 5%, respectively, for the year ended December 31, 2017, compared to the prior year. Revenue per carload/unit increased by 6% due to mix, increased average length of haul, positive pricing impacts, and higher fuel surcharge. Energy revenues increased $81.1 million, primarily due to an increase in utility coal volumes due to higher natural gas prices and lower coal inventory levels. In addition, frac sand volumes increased due to strong demand as a result of higher crude oil prices. Chemical and petroleum revenues increased $64.5 million, primarily due to increased refined product and liquefied petroleum gas shipments to Mexico. The increase in revenue per carload/unit was partially offset by the weakening of the Mexican peso against the U.S. dollar of approximately $8.0 million, compared to the prior year, for revenue transactions denominated in Mexican pesos. The average exchange rate of Mexican pesos per U.S. dollar was Ps.18.9 for 2017 compared to Ps.18.7 for 2016.
KCS’s fuel surcharges are a mechanism to adjust revenue based upon changes in fuel prices above fuel price thresholds set in KCS’s tariffs or contracts. Fuel surcharge revenue is calculated using a fuel price from a prior time period that can be up to 60 days earlier. In a period of volatile fuel prices or changing customer business mix, changes in fuel expense and fuel surcharge revenue may differ.
Fuel surcharge revenue increased $65.7 million for the year ended December 31, 2017, compared to the prior year, due to higher fuel prices and the impact of fuel prices increasing above the fuel price thresholds for certain of KCS’s tariffs and contracts. Additionally, fuel surcharge increased due to separating the fuel surcharge for certain customers from the line haul rate, as well as increased volumes.
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The following discussion provides an analysis of revenues by commodity group:
Revenues by commodity
group for 2017
Chemical and petroleum. Revenues increased $64.5 million for the year ended December 31, 2017, compared to 2016, due to a 7% increase in revenue per carload/unit and a 6% increase in carload/unit volumes. Revenue per carload/unit increased due to longer average length of haul and positive pricing impacts. Petroleum volumes increased due to refined product and liquefied petroleum gas shipments to Mexico. |  |
Industrial and consumer products. Revenues increased $34.3 million for the year ended December 31, 2017, compared to 2016, due to a 4% increase in carload/unit volumes and a 2% increase in revenue per carload/unit. Other carloads’ volumes increased due to strong military movements. Revenue per carload/unit increased due to higher fuel surcharge, metals and scrap longer average length of haul, and positive pricing impacts. |  |
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Revenues by commodity
group for 2017
Agriculture and minerals. Revenues increased $16.4 million for the year ended December 31, 2017 compared to 2016, due to a 7% increase in revenue per carload/unit, partially offset by a 3% decrease in carload/unit volumes. Revenue per carload/unit increased due to positive pricing impacts, longer average length of haul, and higher fuel surcharge. Food products volumes decreased due to change in market demand. |  |
Energy. Revenues increased $81.1 million for the year ended December 31, 2017, compared to 2016, due to a 22% increase in revenue per carload/unit and a 15% increase in carload/unit volumes. Revenues per carload/unit increased due to longer average length of haul, positive pricing impacts, mix, and higher fuel surcharge. Utility coal volumes increased due to higher natural gas prices and lower coal inventory levels. Additionally, frac sand volumes increased due to strong demand as a result of higher crude oil prices. |  |
Intermodal. Revenues increased $6.2 million for the year ended December 31, 2017, compared to 2016, due to a 2% increase in carload/unit volumes, partially offset by a 1% decrease in revenue per carload/unit. The volume increase was attributable to new business and lower volumes in second half of 2016 due to service disruptions from protests, partially offset by truck capacity in the U.S. and Mexico. Revenue per carload/unit decreased due to shorter average length of haul and mix.
Automotive. Revenues increased $40.9 million for the year ended December 31, 2017, compared to 2016, due to a 17% increase in carload/unit volumes and a 4% increase in revenue per carload/unit. Volumes increased due to customers’ temporary plant shutdowns in the first half of 2016, the introduction of new automobile models, and new plant openings. Revenue per carload/unit increased due to higher fuel surcharge and positive pricing impacts, partially offset by the weakening of the Mexican peso against the U.S. dollar.
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Operating Expenses
Operating expenses, as shown below (in millions), increased $145.6 million for the year ended December 31, 2017, compared to 2016, primarily due to higher fuel prices and consumption, and compensation and benefits. The weakening of the Mexican peso against the U.S. dollar resulted in an expense reduction of approximately $5.0 million for expense transactions denominated in Mexican pesos. The average exchange rate of Mexican pesos per U.S. dollar was Ps.18.9 for 2017 compared to Ps.18.7 for 2016.
Change | ||||||||||||||
2017 | 2016 | Dollars | Percent | |||||||||||
Compensation and benefits | $ | 493.8 | $ | 462.4 | $ | 31.4 | 7 | % | ||||||
Purchased services | 193.7 | 208.5 | (14.8 | ) | (7 | %) | ||||||||
Fuel | 316.1 | 253.8 | 62.3 | 25 | % | |||||||||
Mexican fuel excise tax credit | (44.1 | ) | (62.8 | ) | 18.7 | (30 | %) | |||||||
Equipment costs | 129.2 | 120.0 | 9.2 | 8 | % | |||||||||
Depreciation and amortization | 320.9 | 305.0 | 15.9 | 5 | % | |||||||||
Materials and other | 251.7 | 228.8 | 22.9 | 10 | % | |||||||||
Total operating expenses | $ | 1,661.3 | $ | 1,515.7 | $ | 145.6 | 10 | % | ||||||
Compensation and benefits. Compensation and benefits increased $31.4 million for the year ended December 31, 2017, compared to 2016, due to increases in annual wages and benefits of approximately $16.0 million. In addition, compensation and benefits increased by approximately $12.0 million due to increased headcount as a result of higher carloads and car repair in Mexico being performed in-house starting in October 2016.
Purchased services. Purchased services expense decreased $14.8 million for the year ended December 31, 2017, compared to 2016, due to car repair in Mexico being performed in-house starting in October 2016, partially offset by increases in repairs and maintenance, joint facilities expenses, computer software expenses, and detours.
Fuel. Fuel expense increased $62.3 million for the year ended December 31, 2017, compared to 2016, due to higher diesel fuel prices of approximately $30.0 million and $21.0 million in Mexico and the U.S., respectively, and higher consumption of approximately $19.0 million, partially offset by the weakening of the Mexican peso of approximately $4.0 million and improved efficiency of approximately $4.0 million. The average price per gallon, inclusive of the impact from the weakening of the Mexican peso, was $2.27 in 2017, compared to $1.95 in 2016.
Mexican fuel excise tax credit. For the year ended December 31, 2017, the Company recognized a $44.1 million benefit, compared to a $62.8 million benefit recognized in 2016. The reduced benefit is due to a lower excise tax rate in effect for 2017 as compared to 2016.
Equipment costs. Equipment costs increased $9.2 million for the year ended December 31, 2017, compared to 2016, due to higher car hire expense resulting from increased automotive business impacting rates and volumes, partially offset by improved efficiency.
Depreciation and amortization. Depreciation and amortization increased $15.9 million for the year ended December 31, 2017, compared to 2016, due to a larger asset base.
Materials and other. Materials and other expense increased $22.9 million for the year ended December 31, 2017, compared to 2016, due to car repair in Mexico being performed in-house starting in October 2016, which resulted in additional materials purchased, and in an increase in casualty derailment expense.
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Non-Operating Expenses
Equity in net earnings of affiliates. Equity in net earnings from affiliates decreased $3.1 million for the year ended December 31, 2017, compared to 2016, as a result of lower equity in net earnings from the operations of PCRC due to a decrease in container volumes.
Interest expense. Interest expense increased $2.5 million for the year ended December 31, 2017, compared to 2016, due to higher average debt balances, partially offset by lower average interest rates as a result of an increased proportion of commercial paper in the overall debt mix. For the year ended December 31, 2017, the average debt balance (including commercial paper) was $2,603.6 million, compared to $2,492.7 million in 2016. The average interest rate for the year ended December 31, 2017 was 3.9%, compared to 4.0% in 2016.
Foreign exchange gain (loss). For the year ended December 31, 2017 foreign exchange gain was $41.7 million, compared to a loss of $72.0 million in 2016. Foreign exchange gain (loss) includes the re-measurement and settlement of net monetary assets denominated in Mexican pesos and the gain (loss) on foreign currency derivative contracts.
For the year ended December 31, 2017, the re-measurement and settlement of net monetary assets denominated in Mexican pesos resulted in a foreign exchange gain of $3.5 million, compared to a loss of $18.5 million in 2016.
The Company enters into foreign currency derivative contracts to hedge its net exposure to fluctuations in the Mexican cash tax obligation due to changes in the value of the Mexican peso against the U.S. dollar. For the year ended December 31, 2017, foreign exchange gain on foreign currency derivative contracts was $38.2 million, compared to a loss of $53.5 million in 2016.
Other expense, net. Other expense, net, decreased $0.4 million for the year ended December 31, 2017, compared to 2016, due to an increase in miscellaneous income.
Income tax expense (benefit). Income tax expense (benefit) decreased $272.4 million for the year ended December 31, 2017, compared to 2016, due to the impact of the Tax Reform Act enacted on December 22, 2017. The Company recognized a $487.6 million tax benefit as a result of revaluing the U.S. ending net deferred tax liabilities from 35% to the newly enacted U.S. corporate income tax rate of 21%. The tax benefit was partially offset by tax expense of $74.6 million for the deemed mandatory repatriation of undistributed earnings. The effective tax rate was (10.2%) and 27.6% for the years ended December 31, 2017 and 2016, respectively. The decrease in the effective tax rate was due to impact of the Tax Reform Act.
The strengthening of the Mexican peso as of December 31, 2017 as compared to December 31, 2016 increased the Company’s Mexican cash tax obligation by $18.8 million for the year ended December 31, 2017, whereas the weakening of the Mexican peso as of December 31, 2016 decreased the Company’s Mexican cash tax obligation by $49.2 million for the year ended December 31, 2016. The Company enters into foreign currency derivative contracts to hedge its net exposure to fluctuations in the Mexican cash tax obligation due to changes in the value of the Mexican peso against the U.S. dollar, and gains and losses on these foreign currency derivative contracts are recorded in foreign exchange gain (loss).
Further information on the components of the effective tax rates for the years ended December 31, 2017 and 2016, is presented in Item 8, Financial Statements and Supplementary Data — Note 13, Income Taxes.
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LIQUIDITY AND CAPITAL RESOURCES
Overview
The Company focuses its cash and capital resources on investing in the business, shareholder returns and optimizing its capital structure.
The Company believes, based on current expectations, that cash and other liquid assets, operating cash flows, access to debt and equity capital markets, and other available financing resources will be sufficient to fund anticipated operating expenses, capital expenditures, debt service costs, dividends, share repurchases and other commitments in the foreseeable future. The Company may, from time to time, incur debt to refinance existing indebtedness, purchase equipment under operating leases, repurchase shares or fund equipment additions or new investments.
During 2018, the Company invested $512.3 million in capital expenditures. See Capital Expenditures section for further details.
During 2018, the Company repurchased 2,272,213 shares of common stock for $243.1 million at an average price of $106.98 per share under the $800.0 million common share repurchase program announced in August 2017. Since inception of this program, the Company has repurchased 4,691,682 shares of common stock at an average price of $106.20 per share and a total cost of $498.3 million. Remaining share repurchases are expected to be funded by cash on hand, cash generated from operations and debt. Management's assessment of market conditions, available liquidity and other factors will determine the timing and volume of any future repurchases. Refer to Item 8, Financial Statements and Supplementary Data — Note 14, Stockholders’ Equity for additional detail on the Company’s common share repurchase program.
During 2018, the Company repurchased 13,775 shares of its $25 par preferred stock for $0.4 million at an average price of $26.23 per share.
On May 3, 2018, KCS issued $500.0 million principal amount of senior unsecured notes, which bear interest semiannually at a fixed annual rate of 4.70% (the “4.70% Senior Notes”). The net proceeds from the offering were used to repay the outstanding commercial paper issued by KCS, repay a locomotive lease and certain equipment loans, and for general corporate purposes.
On May 3, 2018, KCSM repurchased $5.3 million of the remaining $10.9 million aggregate principal amount of its 3.0% senior unsecured notes due May 15, 2023, at a discounted price equal to 95.91% of the principal amount.
During May 2018, the Company paid the remaining $23.0 million and $19.1 million principal amounts under its locomotive financing agreements with Export Development Canada and DVB Bank AG, respectively, using a portion of the proceeds from the issuance of the 4.70% Senior Notes.
The Company’s financing instruments contain restrictive covenants which limit or preclude certain actions; however, the covenants are structured such that the Company expects to have sufficient flexibility to conduct its operations. The Company was in compliance with all of its debt covenants as of December 31, 2018.
For discussion regarding the agreements representing the indebtedness of KCS, see Item 8, Financial Statements and Supplementary Data — Note 11, Short-Term Borrowings and Note 12, Long-Term Debt.
During 2018, the Company’s Board of Directors declared quarterly cash dividends of $0.36 per share or $146.7 million on its common stock. Subject to the discretion of the Board of Directors, capital availability and a determination that cash dividends continue to be in the best interest of its stockholders, the Company intends to pay a quarterly dividend on an ongoing basis.
On December 31, 2018, total available liquidity (the cash balance plus revolving credit facility availability) was $900.5 million, compared to available liquidity at December 31, 2017 of $588.9 million. This increase was primarily due to the issuance of the 4.70% Senior Notes, a portion of which were used to pay down KCS’s outstanding commercial paper during 2018.
As of December 31, 2018, the total cash and cash equivalents held outside of the U.S. in foreign subsidiaries was $27.9 million, after repatriating $233.8 million during 2018. The Company expects that this cash will be available to fund company operations without incurring significant additional income taxes.
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In December 2018, the Mexican government enacted Mexico Tax Reform. Mexico Tax Reform eliminated “universal compensation” that allowed Mexican taxpayers to offset recoverable tax balances against balances due for other federal taxes. The elimination of “universal compensation” could negatively impact the timing of KCSM’s cash flow by up to $60.0 million in 2019 while awaiting refunds of value added tax from the Mexican government.
Cash Flow Information and Contractual Obligations
Summary cash flow data follows (in millions):
2018 | 2017 | 2016 | |||||||||
Cash flows provided by (used for): | |||||||||||
Operating activities | $ | 945.7 | $ | 1,028.4 | $ | 919.0 | |||||
Investing activities | (651.9 | ) | (681.1 | ) | (628.2 | ) | |||||
Financing activities | (327.4 | ) | (383.8 | ) | (256.8 | ) | |||||
Net increase (decrease) in cash and cash equivalents | (33.6 | ) | (36.5 | ) | 34.0 | ||||||
Cash and cash equivalents beginning of year | 134.1 | 170.6 | 136.6 | ||||||||
Cash and cash equivalents end of year | $ | 100.5 | $ | 134.1 | $ | 170.6 | |||||
During 2018 and 2017, cash and cash equivalents decreased $33.6 million and $36.5 million, respectively, as a result of the impacts discussed in the paragraphs below.
Operating Cash Flows. Net cash provided by operating activities decreased $82.7 million for 2018, as compared to 2017, primarily due to an increase in Mexican income tax payments of $145.2 million, partially offset by an increase in operating income of $64.7 million. Net cash provided by operating activities increased $109.4 million for 2017, as compared to 2016, due to increased operating income of $103.1 million.
Investing Cash Flows. Net cash used for investing activities decreased $29.2 million for 2018, as compared to 2017, due to a $65.1 million decrease in capital expenditures, a $11.8 million decrease in cash outflows for other investing activities and $7.6 million of insurance proceeds received in 2018 relating to 2017 hurricane damage, partially offset by a $56.3 million increase in expenditures for the purchase or replacement of equipment under existing operating leases. Net cash used for investing activities increased $52.9 million for 2017, as compared to 2016, due to a $21.8 million increase in capital expenditures, a $19.5 million increase in investments in and advances to affiliates and a $16.0 million increase in expenditures for the purchase or replacement of equipment under existing operating leases. Additional capital expenditure information is included within the Capital Expenditure section of Liquidity and Capital Resources.
Financing Cash Flows. Net cash used for financing activities decreased $56.4 million for 2018, as compared to 2017, due to an increase in proceeds from long-term debt of $499.4 million and a decrease in shares repurchased of $132.1 million as a result of the $200.0 million accelerated share repurchase program that was executed in the third quarter of 2017. These decreases were partially offset by an increase in the net repayment of short-term borrowings of $507.1 million, an increase in repayment of long-term debt of $56.1 million and an increase in debt costs of $8.0 million. Net cash used for financing activities increased $127.0 million for 2017, as compared to 2016, due to an increase in the repurchase of common stock of $190.2 million, partially offset by an increase in net proceeds from short-term borrowings of $58.2 million.
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Contractual Obligations. The following table outlines the material obligations and commitments as of December 31, 2018 (in millions):
Payments Due by Period | |||||||||||||||||||
Total | Less Than 1 Year | 1-3 Years | 3-5 Years | More than 5 years | |||||||||||||||
Long-term debt and short-term borrowings (including interest and capital lease obligations) (i) | $ | 4,752.8 | $ | 119.6 | $ | 503.8 | $ | 848.8 | $ | 3,280.6 | |||||||||
Operating leases | 205.3 | 57.5 | 69.6 | 32.2 | 46.0 | ||||||||||||||
Deemed mandatory repatriation tax (ii) | 11.3 | — | — | 2.5 | 8.8 | ||||||||||||||
Obligations due to uncertainty in income taxes | 2.2 | — | — | 2.2 | — | ||||||||||||||
Capital expenditure obligations (iii) | 276.6 | 141.2 | 135.4 | — | — | ||||||||||||||
Other contractual obligations (iv) | 681.3 | 230.2 | 133.9 | 110.4 | 206.8 | ||||||||||||||
Total | $ | 5,929.5 | $ | 548.5 | $ | 842.7 | $ | 996.1 | $ | 3,542.2 | |||||||||
(i) | For variable rate obligations, interest payments were calculated using the December 31, 2018 rate. For fixed rate obligations, interest payments were calculated based on the applicable rates and payment dates. |
(ii) | U.S. federal income tax on deemed mandatory repatriation is payable over 8 years pursuant to the Tax Reform Act. |
(iii) | Capital expenditure obligations include minimum capital expenditures under the KCSM Concession agreement and other regulatory requirements. |
(iv) | Other contractual obligations include purchase commitments and certain maintenance agreements. |
In the normal course of business, the Company enters into long-term contractual commitments for future goods and services needed for the operations of the business. Such commitments are not in excess of expected requirements and are not reasonably likely to result in performance penalties or payments that would have a material adverse effect on the Company’s liquidity. Such commitments are not included in the above table.
The SCT requires KCSM to submit a three-year capital expenditures plan every three years. The most recent three-year plan was submitted in 2017 for the years 2018 — 2020. KCSM expects to continue capital spending at current levels in future years and will continue to have capital expenditure obligations past 2020, which are not included in the table above.
Off-Balance Sheet Arrangements
On November 2, 2007, PCRC completed an offering of $100.0 million of 7.0% senior secured notes due November 1, 2026 (the “Notes”). The Notes are senior obligations of PCRC, secured by certain assets of PCRC. KCS has pledged its shares of PCRC as security for the Notes. The Notes are otherwise non-recourse to KCS. The Company has agreed, along with Mi-Jack Products, Inc. (“Mi-Jack”), the other 50% owner of PCRC, to each fund 50% of any debt service reserve and liquidity reserve (reserves which are required to be established by PCRC in connection with the issuance of the Notes). As of December 31, 2018, the Company’s portion of these reserves was $5.6 million. The Company has issued a standby letter of credit in the amount of $5.6 million to fund its share of these reserves.
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Capital Expenditures
KCS has funded, and expects to continue to fund, capital expenditures with operating cash flows and short and long-term debt.
The following table summarizes capital expenditures by type for the years ended December 31, 2018, 2017, and 2016, respectively (in millions):
2018 | 2017 | 2016 | ||||||||||
Roadway capital program | $ | 245.7 | $ | 269.3 | $ | 271.8 | ||||||
Locomotives and freight cars | 101.2 | 75.7 | 112.6 | |||||||||
Capacity | 69.8 | 111.4 | 109.6 | |||||||||
Positive train control | 28.9 | 51.7 | 49.6 | |||||||||
Information technology | 35.4 | 33.7 | 29.3 | |||||||||
Other | 31.3 | 17.7 | 11.1 | |||||||||
Total capital expenditures (accrual basis) | 512.3 | 559.5 | 584.0 | |||||||||
Change in capital accruals | 8.0 | 25.9 | (20.4 | ) | ||||||||
Total cash capital expenditures | $ | 520.3 | $ | 585.4 | $ | 563.6 | ||||||
Purchase or replacement of equipment under operating leases: | ||||||||||||
Locomotives | $ | 50.6 | $ | — | $ | — | ||||||
Freight cars | 49.9 | 42.6 | 26.6 | |||||||||
Total purchase or replacement of equipment under operating leases (accrual basis) | 100.5 | 42.6 | 26.6 | |||||||||
Change in capital accruals | (1.6 | ) | — | — | ||||||||
Total cash purchase or replacement of equipment under operating leases | $ | 98.9 | $ | 42.6 | $ | 26.6 | ||||||
Generally, the Company’s capital program consists of capital replacement and equipment. For 2019, internally generated cash flows are expected to fund cash capital expenditures, which are currently estimated to be between $640.0 million and $660.0 million. In addition, the Company periodically reviews its equipment and property under operating leases. Any additional purchase or replacement of equipment and property under operating leases during 2019 is expected to be funded with internally generated cash flows and/or debt. The locomotive operating lease buyout shown in the table above was completed using a portion of the proceeds from the issuance of the 4.70% Senior Notes.
Property Statistics
The following table summarizes certain property statistics as of December 31:
2018 | 2017 | 2016 | ||||||
Track miles of rail installed | 166 | 174 | 146 | |||||
Cross ties installed (thousands) | 651 | 699 | 711 | |||||
Shelf Registration Statements and Public Securities Offerings
KCS has one current, universal shelf registration statement on file with the SEC (the “Universal Shelf” — Registration No. 333-221537). The Universal Shelf was filed on November 13, 2017 in accordance with the securities offering reform rules of the SEC that allow “well-known seasoned issuers” to register an unspecified amount of different types of securities on an immediately effective Form S-3 registration statement. The Universal Shelf will expire on November 13, 2020.
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CRITICAL ACCOUNTING POLICIES AND ESTIMATES
KCS’s accounting and financial reporting policies are in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”). The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Management believes that the following accounting policies and estimates are critical to an understanding of KCS’s historical and future performance. Management has discussed the development and selection of the following critical accounting estimates with the Audit Committee of KCS’s Board of Directors and the Audit Committee has reviewed the selection, application and disclosure of the Company’s critical accounting policies and estimates.
Capitalization, Depreciation and Amortization of Property and Equipment (including Concession Assets)
Due to the highly capital intensive nature of the railroad industry, capitalization and depreciation of property and equipment are a substantial portion of the Company’s consolidated financial statements. Net property and equipment, including concession assets, comprised approximately 92% of the Company’s total assets as of December 31, 2018, and related depreciation and amortization comprised approximately 20% of total operating expenses for the year ended December 31, 2018.
KCS capitalizes costs for self-constructed additions and improvements to property including direct labor and material, indirect overhead costs, and interest during long-term construction projects. Direct costs are charged to capital projects based on the work performed and the material used. Indirect overhead costs are allocated to capital projects as a standard percentage, which is evaluated annually, and applied to direct labor and material costs. Asset removal activities are performed in conjunction with replacement activities; therefore, removal costs are estimated based on a standard percentage of direct labor and indirect overhead costs related to capital replacement projects. For purchased assets, all costs necessary to make the asset ready for its intended use are capitalized. Expenditures that significantly increase asset values, productive capacity, efficiency, safety or extend useful lives are capitalized. Repair and maintenance costs are expensed as incurred.
Property and equipment are carried at cost and are depreciated primarily on the group method of depreciation, which the Company believes closely approximates a straight line basis over the estimated useful lives of the assets measured in years. The group method of depreciation applies a composite rate to classes of similar assets rather than to individual assets. Composite depreciation rates are based upon the Company’s estimates of the expected average useful lives of assets as well as expected net salvage value at the end of their useful lives. In developing these estimates, the Company utilizes periodic depreciation studies performed by an independent engineering firm. Depreciation rate studies are performed at least every three years for equipment and at least every six years for road property (rail, ties, ballast, etc.). The depreciation studies take into account factors such as:
• | Statistical analysis of historical patterns of use and retirements of each asset class; |
• | Evaluation of any expected changes in current operations and the outlook for the continued use of the assets; |
• | Evaluation of technological advances and changes to maintenance practices; and |
• | Historical and expected salvage to be received upon retirement. |
The depreciation studies may also indicate that the recorded amount of accumulated depreciation is deficient or in excess of the amount indicated by the study. Any such deficiency or excess is amortized as a component of depreciation expense over the remaining useful lives of the affected asset class, as determined by the study. The Company also monitors these factors in non-study years to determine if adjustments should be made to depreciation rates. The Company performed depreciation studies for KCSR in 2018 and KCSM in 2016. The impacts of the studies were immaterial to the consolidated financial results for all periods.
Also under the group method of depreciation, the cost of railroad property and equipment (net of salvage or sales proceeds) retired or replaced in the normal course of business is charged to accumulated depreciation with no gain or loss recognized. Actual historical costs are retired when available, such as with equipment costs. The use of estimates in recognizing the retirement of roadway assets is necessary as it is impractical to track individual, homogeneous network-type assets. Certain types of roadway assets are retired using statistical curves derived from the depreciation studies that indicate the relative distribution of the age of the assets retired. For other roadway assets, historical costs are estimated by (1) deflating current costs
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using inflation indices published by the U.S. Bureau of Labor Statistics and (2) the estimated useful life of the assets as determined by the depreciation studies. The indices applied to the replacement value are selected because they closely correlate with the major costs of the items comprising the roadway assets. Because of the number of estimates inherent in the depreciation and retirement processes and because it is impossible to precisely estimate each of these variables until a group of assets is completely retired, the Company continually monitors the estimated useful lives of its assets and the accumulated depreciation associated with each asset group to ensure the depreciation rates are appropriate.
Estimation of the average useful lives of assets and net salvage values requires management judgment. Estimated average useful lives may vary over time due to changes in physical use, technology, asset strategies and other factors that could have an impact on the retirement experience of the asset classes. Accordingly, changes in the assets’ estimated useful lives could significantly impact future periods’ depreciation expense. Depreciation and amortization expense for the year ended December 31, 2018 was $346.7 million. If the weighted average useful lives of assets were changed by one year, annual depreciation and amortization expense would change approximately $11.0 million.
Gains or losses on dispositions of land or non-group property and abnormal retirements of railroad property are recognized through income. A retirement of railroad property would be considered abnormal if the cause of the retirement is unusual in nature and its actual life is significantly shorter than what would be expected for that group based on the depreciation studies. An abnormal retirement could cause the Company to re-evaluate the estimated useful life of the impacted asset class. There were no significant gains or losses from abnormal retirements of property or equipment for any of the three years ended December 31, 2018.
Costs incurred by the Company to acquire the concession rights and related assets, as well as subsequent improvements to the concession assets, are capitalized and amortized using the group method of depreciation over the lesser of the current expected Concession term, including probable renewal of an additional 50-year term, or the estimated useful lives of the assets and rights. The Company’s ongoing evaluation of the useful lives of concession assets and rights considers the aggregation of the following facts and circumstances:
• | The Company’s executive management is dedicated to ensuring compliance with the various provisions of the Concession and to maintaining positive relationships with the SCT and other Mexican federal, state, and municipal governmental authorities; |
• | During the time since the Concession was granted, the relationships between KCSM and the various Mexican governmental authorities have matured and the guidelines for operating under the Concession have become more defined with experience; |
• | There are no known supportable sanctions or compliance issues that would cause the SCT to revoke the Concession or prevent KCSM from renewing the Concession; and |
• | KCSM operations are an integral part of the KCS operations strategy, and related investment analyses and operational decisions assume that the Company’s cross border rail business operates into perpetuity, and do not assume that Mexico operations terminate at the end of the current Concession term. |
Based on the above factors, as of December 31, 2018, the Company continues to believe that it is probable that the Concession will be renewed for an additional 50-year term beyond the current term.
Long-lived assets are reviewed for impairment when events or circumstances indicate that the carrying amount of an asset may not be recoverable. If impairment indicators are present and the estimated future undiscounted cash flows are less than the carrying value of the long-lived assets, the carrying value would be reduced to the estimated fair value. Future cash flow estimates for an impairment review would be based on the lowest level of identifiable cash flows, which are the Company’s U.S. and Mexican operations. During the years ended December 31, 2018 and 2017, management did not identify any indicators of impairment.
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Income Taxes
Deferred income taxes represent a net asset or liability of the Company. For financial reporting purposes, management determines the current tax liability, as well as deferred tax assets and liabilities, in accordance with the asset and liability method of accounting for income taxes. The provision for income taxes is the sum of income taxes both currently payable and deferred into the future. Currently payable income taxes represent the liability related to the Company’s U.S., state and foreign income tax returns for the current year and anticipated tax payments resulting from income tax audits, while the net deferred tax expense or benefit represents the change in the balance of net deferred tax assets or liabilities as reported on the balance sheet. The changes in deferred tax assets and liabilities are determined based upon the estimated timing of reversal of differences between the carrying amount of assets and liabilities for financial reporting purposes and the basis of assets and liabilities for tax purposes as measured using the currently enacted tax rates that will be in effect at the time these differences are expected to reverse. Additionally, management estimates whether taxable operating income in future periods will be sufficient to fully recognize any deferred tax assets. Valuation allowances are recorded as appropriate to reduce deferred tax assets to the amount considered likely to be realized.
On December 22, 2017, the President of the United States signed into law the Tax Reform Act. The legislation significantly changed U.S. tax law by, among other things, lowering corporate income tax rates, implementing a territorial tax system and imposing a repatriation tax on deemed repatriated earnings of foreign subsidiaries. The Tax Reform Act permanently reduced the U.S. corporate income tax rate from a maximum of 35% to a flat 21% rate, effective January 1, 2018. The SEC staff issued Staff Accounting Bulletin No. 118 (“SAB 118”) to address the application of U.S. GAAP in situations when a registrant did not have the necessary information available, prepared, or analyzed (including computations) in reasonable detail to complete the accounting for certain income tax effects of the Tax Reform Act. The Company recognized provisional tax impacts related to the deemed repatriated earnings and the revaluation of deferred tax assets and liabilities in its consolidated financial statements for the year ended December 31, 2017. Adjustments made to the provisional amounts allowed under SAB 118 were identified and recorded as discrete adjustments during the year ended December 31, 2018. The accounting was completed in the fourth quarter of 2018.
Income tax expense related to Mexican operations has additional complexities such as the impact of exchange rate variations, which can have a significant impact on the effective income tax rate.
Management believes that the assumptions and estimates related to the provision for income taxes are critical to the Company’s results of operations. For the year ended December 31, 2018, income tax expense totaled $257.5 million. For every 1% change in the 2018 effective rate, income tax expense would have changed by approximately $8.9 million. For further information on the impact of foreign exchange fluctuation on income taxes, refer to Item 7A, Quantitative and Qualitative Disclosures About Market Risk — Foreign Exchange Sensitivity.
OTHER MATTERS
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 provisions that 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 as described in Item 8, Financial Statements and Supplementary Data — Note 16, Commitments and Contingencies, such proceedings and actions should not, individually or in the aggregate, have a material adverse effect on the Company’s consolidated financial statements.
Inflation. U.S. generally accepted accounting principles require the use of historical cost, which does not reflect the effects of inflation on the replacement cost of property. Due to the capital intensive nature of KCS’s business, the replacement cost of these assets would be significantly higher than the amounts reported under the historical cost basis.
Recent Accounting Pronouncements. Refer to Item 8, Financial Statements and Supplementary Data — Note 2, Significant Accounting Policies for information relative to recent accounting pronouncements.
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Regulatory Updates
Mexican Antitrust Law. Pursuant to the Mexican Antitrust Law and the Regulatory Railroad Service Law, the Investigating Authority of the Mexican government’s antitrust commission (Comisión Federal de Competencia Económica or the “COFECE”) announced in September 2016 that it would review competitive conditions in the Mexican railroad industry, with respect to the existence of effective competition in the provision of interconnection services, trackage rights, switching rights and interline services used to render public freight transport in Mexico. The review included the entire freight rail transportation market in Mexico and was not targeted to any single rail carrier.
On March 15, 2017, the Investigating Authority published an executive summary of its preliminary report in the Federal Official Gazette (Diario Oficial de la Federación). The preliminary report concluded that there was a lack of effective competition in the market for trackage rights (“Relevant Market”) throughout the entire networks of KCSM, Ferrocarril Mexicano, S.A. de C.V., Ferrosur, S.A. de C.V., and FTVM.
The Company disagreed with the Investigating Authority’s reasoning and preliminary conclusions, and responded on April 20, 2017, with its evidence and arguments to support its position, as provided in the Mexican antitrust law. The Company’s response argued that the investigation which supported the conclusions in the preliminary report was conducted contrary to the rule of law, the rules of procedure, and relied upon faulty economic analysis.
On March 7, 2018, KCSM received the Final Resolution handed down by the COFECE Panel in connection with the investigation regarding effective competition in the market for interconnection services, trackage rights and switching rights used to provide railway freight public services in the rail freight industry.
The Final Resolution dismissed the preliminary report issued by the Investigating Authority along with that report’s finding of a lack of effective competition for interconnection services. The Final Resolution represents the end of the investigation and no further amendments or modifications may be made to the preliminary report.
USMCA. On November 30, 2018, U.S. President Trump, Canadian Prime Minister Trudeau, and then-Mexican President Peña Nieto signed the U.S.-Mexico-Canada-Agreement (“USMCA”). The agreement would serve as a successor to the 1994 North American Free Trade Agreement (“NAFTA”). The USMCA will not become effective until all three parties have completed their respective domestic ratification procedures.
In the United States, congressional review and approval of the USMCA is done under the Bipartisan Trade Priorities and Accountability Act of 2015. Implementing legislation is expected to be introduced in Congress possibly in the first quarter of 2019.
U.S. Tariff Imposition on Imports. The administration of U.S. President Donald J. Trump has implemented new U.S. tariffs, that could impact the level of trade between the U.S and Mexico and global commerce. U.S. trading partners have responded by announcing retaliatory tariffs on some U.S. exports. At this time, the Company cannot determine the impacts these tariffs will have on the Company’s consolidated financial statements.
Item 7A. | Quantitative and Qualitative Disclosures About Market Risk |
KCS is exposed to certain market risks including interest rate, commodity, and foreign exchange risks and utilizes various financial instruments that have certain inherent market risks. These instruments have been entered into for hedging rather than trading purposes. The following information, together with information included in Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Financial Statements and Supplementary Data — Note 10, Derivative Instruments, describe the key aspects of certain financial instruments that have market risk to KCS.
The analysis presented below for each of the Company's market risks uses a sensitivity model based on hypothetical changes (increases or decreases) to market risks using defined parameters and assumptions to quantify the potential impacts to the consolidated statements of income. The hypothetical changes to market risks do not represent KCS's view of future market changes. The effect of a change in a particular assumption was calculated without adjusting any other assumptions. These market risks and the potential impacts to the consolidated statements of income for the current year, have not materially fluctuated, individually or in the aggregate from the preceding year; thus only current year information is presented below.
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Interest Rate Sensitivity. The Company is subject to interest rate risk associated with its debt. Changes in interest rates impact the fair value of outstanding fixed-rate debt, but there is no impact to current earnings or cash flow. Based upon the borrowing rates available to KCS and its subsidiaries for indebtedness with similar terms and average maturities, the fair value of long-term debt was approximately $2,661.3 million and $2,377.8 million at December 31, 2018 and 2017, respectively, compared with a carrying value of $2,689.4 million and $2,274.3 million at December 31, 2018 and 2017, respectively.
Changes in interest rates may impact the cost of future long-term debt issued by the Company, and as a result, represent interest rate risk to the Company. In May 2017, the Company executed four treasury lock agreements with an aggregate notional value of $275.0 million and a weighted-average interest rate of 2.85%. The purpose of the treasury locks is to hedge the U.S. Treasury benchmark interest rate associated with future interest payments related to the anticipated refinancing of the $275.0 million of 2.35% senior notes due May 15, 2020. The Company has designated the treasury locks as cash flow hedges, and for the year ended December 31, 2018, recognized an unrealized gain of $2.6 million, net of tax, in the consolidated statements of comprehensive income. A hypothetical 100 basis points change in the ten-year U.S. Treasury Rate would result in a change in unrealized gain or loss of approximately $24.0 million. Upon settlement in 2020, the unrealized gain or loss in accumulated other comprehensive income will be amortized to interest expense over the life of the future underlying debt issuance.
Alternatively, changes in interest rates do not affect the fair value of variable rate debt, but affect future earnings and cash flows. The Company's floating-rate indebtedness includes commercial paper borrowings, and any outstanding borrowings under revolving credit facilities. At December 31, 2018, KCS had no commercial paper or revolving credit facility borrowings outstanding. At December 31, 2017, KCS had outstanding commercial paper borrowings of $345.2 million, and no borrowings outstanding under the revolving credit facility.
Commodity Price Sensitivity. KCS periodically participates in diesel fuel purchase commitments and derivative financial instruments. At December 31, 2018 and 2017, KCS did not have any outstanding fuel derivative financial instruments. The Company also holds fuel inventories for use in operations. These inventories are not material to KCS’s overall financial position. Fuel costs are expected to reflect market conditions in 2019; however, fuel costs are unpredictable and subject to a variety of factors outside the Company’s control. Assuming annual consumption of 135 million gallons, a hypothetical 10 cent change in the price per gallon of fuel would cause a $13.5 million change in operating expenses. KCS mitigates the impact of increased fuel costs through fuel surcharge revenues from customers; however, in a period of volatile fuel prices or changing customer business mix, changes in fuel expense and fuel surcharge revenue may differ.
Foreign Exchange Sensitivity. KCS’s foreign subsidiaries use the U.S. dollar as their functional currency; however, a portion of the foreign subsidiaries’ revenues and expenses is denominated in Mexican pesos. Based on the volume of revenue and expense transactions denominated in Mexican pesos, revenue and expense fluctuations have historically offset.
The Company has exposure to fluctuations in the value of the Mexican peso against the U.S. dollar due to its monetary assets and liabilities that are denominated in Mexican pesos. Monetary assets and liabilities include cash, accounts receivable and payable and other items that will convert to cash in the future and are remeasured into dollars using the current exchange rate. The remeasurement and settlement of monetary assets and liabilities is recognized in the consolidated statements of income as foreign exchange gains and losses. At December 31, 2018, the Company had Ps.799.7 million of net monetary assets denominated in Mexican pesos, as monetary assets exceeded monetary liabilities.
The following table presents the potential impacts to the consolidated statements of income that would result from a hypothetical change in the exchange rate of one Mexican peso per U.S. dollar at December 31, 2018:
Hypothetical Change in Exchange Rate | Amount of Gain (Loss) | Affected Line Item in the Consolidated Statements of Income | ||||
Net monetary assets denominated in Mexican pesos at December 31, 2018: | ||||||
Ps.799.7 million | From Ps.19.7 to Ps.20.7 | ($2.0 million) | Foreign exchange gain (loss) | |||
Ps.799.7 million | From Ps.19.7 to Ps.18.7 | $2.2 million | Foreign exchange gain (loss) | |||
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Mexican income taxes are paid in Mexican pesos, and as a result, the effective income tax rate reflects fluctuations in the value of the Mexican peso against the U.S. dollar. Most significantly, any gain or loss from the revaluation of the Company’s net U.S. dollar-denominated monetary liabilities into Mexican pesos is included in Mexican taxable income under Mexican tax law. As a result, a strengthening of the Mexican peso against the U.S. dollar for the reporting period will generally increase the Mexican cash tax obligation and the effective income tax rate, and a weakening of the Mexican peso against the U.S. dollar for the reporting period will generally decrease the Mexican cash tax obligation and the effective tax rate.
The following table presents the potential impacts to the effective income tax rate and income tax expense that would result from a hypothetical change in the exchange rate of one Mexican peso at December 31, 2018:
Hypothetical Change in Exchange Rate | Increase (Decrease) in Effective Income Tax Rate | Amount of Expense (Benefit) | Affected Line Item in the Consolidated Statements of Income | |||
From Ps.19.7 to Ps.20.7 | (1.7%) | ($14.8 million) | Income tax expense (benefit) | |||
From Ps.19.7 to Ps.18.7 | 1.8% | $16.4 million | Income tax expense (benefit) | |||
The Company has executed, and expects to continue to execute foreign currency derivative instruments to hedge its exposure to fluctuations in the Mexican cash tax obligation due to changes in the value of the Mexican peso against the U.S. dollar. These derivative instruments have historically offset the effects of foreign currency changes on income tax expense (benefit) resulting in minimal impact to net income.
At December 31, 2018, the Company had outstanding foreign currency option contracts known as zero-cost collars with an aggregate notional amount of $120.0 million. Given the maturity date of January 2019, the Company believes there was minimal market risk associated with these contracts at December 31, 2018. The zero-cost collars matured in January 2019 and resulted in cash received of $0.3 million.
At December 31, 2018, the Company had outstanding foreign currency forward contracts with an aggregate notional amount of $20.0 million. These contracts mature September 30, 2019, and obligate the Company to purchase a total of Ps.410.9 million at a weighted-average exchange rate of Ps. 20.5 to each U.S. dollar.
During January 2019, the Company entered into several foreign currency forward contracts with an aggregate notional amount of $290.0 million and maturity dates throughout 2019. These contracts obligate the company to purchase a total of Ps.5,754.9 million at a weighted-average exchange rate of Ps.19.84 to each U.S. dollar.
The following table presents the potential impacts to the consolidated statements of income that would result from a hypothetical change in the exchange rate of one Mexican peso at maturity date for the foreign currency forward contracts outstanding at December 31, 2018 and those entered into during January 2019:
Aggregate notional amount: | Hypothetical Change in Exchange Rate | Amount of Gain (Loss) | Affected Line Item in the Consolidated Statements of Income | |||
$310.0 million | From Ps.19.9 to Ps.20.9 | ($14.8 million) | Foreign exchange gain (loss) | |||
$310.0 million | From Ps.19.9 to Ps.18.9 | $16.4 million | Foreign exchange gain (loss) | |||
The Company has not designated these foreign currency derivative instruments as hedging instruments for accounting purposes. The foreign currency derivative instruments will be measured at fair value each period and any change in fair value will be recognized in foreign exchange gain (loss) within the consolidated statements of income.
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Item 8. | Financial Statements and Supplementary Data |
Index to Consolidated Financial Statements
Page | |
Financial Statement Schedules: | |
All schedules are omitted because they are not applicable, are insignificant, or the required information is shown in the consolidated financial statements or notes thereto.
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Management’s Report on Internal Control over Financial Reporting
The management of Kansas City Southern is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. KCS’s internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2018, based on the framework established by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control — Integrated Framework (2013) (commonly referred to as the COSO Framework). Based on its evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2018, based on the criteria outlined in the COSO Framework.
The effectiveness of the Company’s internal control over financial reporting as of December 31, 2018, has been audited by PricewaterhouseCoopers LLP, an independent registered public accounting firm, as stated in their report, which immediately follows this report.
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Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Kansas City Southern
Opinions on the Financial Statements and Internal Control over Financial Reporting
We have audited the accompanying consolidated balance sheet of Kansas City Southern and its subsidiaries (“the Company”) as of December 31, 2018, and the related consolidated statements of income, comprehensive income, changes in equity and cash flows for the year then ended, including the related notes (collectively referred to as the “consolidated financial statements”). We also have audited the Company's internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2018, and the results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2018, based on criteria established in Internal Control - Integrated Framework (2013) issued by the COSO.
Basis for Opinions
The Company's management is responsible for these consolidated financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management's Report on Internal Control over Financial Reporting. Our responsibility is to express opinions on the Company’s consolidated financial statements and on the Company's internal control over financial reporting based on our audit. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audit in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud, and whether effective internal control over financial reporting was maintained in all material respects.
Our audit of the consolidated financial statements included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audit also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
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Definition and Limitations of Internal Control over Financial Reporting
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
/s/PricewaterhouseCoopers LLP
Kansas City, Missouri
January 25, 2019
We have served as the Company’s auditor since 2017.
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Report of Independent Registered Public Accounting Firm
To the Stockholders and Board of Directors
Kansas City Southern:
Opinion on the Consolidated Financial Statements
We have audited the accompanying consolidated balance sheet of Kansas City Southern and subsidiaries (the Company) as of December 31, 2017, and the related consolidated statements of income, comprehensive income, changes in equity, and cash flows for each of the years in the two-year period ended December 31, 2017, and the related notes (collectively, the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2017, and the results of its operations and its cash flows for each of the years in the two-year period ended December 31, 2017, in conformity with U.S. generally accepted accounting principles.
Basis for Opinion
These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.
We conducted our audits in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.
/s/ KPMG LLP
We have served as the Company’s auditor from 2001 to 2018.
Kansas City, Missouri
January 26, 2018
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Kansas City Southern and Subsidiaries
Consolidated Statements of Income
Years Ended December 31,
2018 | 2017 | 2016 | |||||||||
(In millions, except share and per share amounts) | |||||||||||
Revenues | $ | 2,714.0 | $ | 2,582.9 | $ | 2,334.2 | |||||
Operating expenses: | |||||||||||
Compensation and benefits | 495.7 | 493.8 | 462.4 | ||||||||
Purchased services | 200.7 | 193.7 | 208.5 | ||||||||
Fuel | 348.2 | 316.1 | 253.8 | ||||||||
Mexican fuel excise tax credit | (37.7 | ) | (44.1 | ) | (62.8 | ) | |||||
Equipment costs | 126.1 | 129.2 | 120.0 | ||||||||
Depreciation and amortization | 346.7 | 320.9 | 305.0 | ||||||||
Materials and other | 265.9 | 251.7 | 228.8 | ||||||||
Gain on insurance recoveries related to hurricane damage | (17.9 | ) | — | — | |||||||
Total operating expenses | 1,727.7 | 1,661.3 | 1,515.7 | ||||||||
Operating income | 986.3 | 921.6 | 818.5 | ||||||||
Equity in net earnings of affiliates | 2.6 | 11.5 | 14.6 | ||||||||
Interest expense | (110.0 | ) | (100.2 | ) | (97.7 | ) | |||||
Debt retirement costs | (2.2 | ) | — | — | |||||||
Foreign exchange gain (loss) | 7.8 | 41.7 | (72.0 | ) | |||||||