UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

Form 10-K

 

 

Commission file number: 1-4717

 

KANSAS CITY SOUTHERN

(Exact name of registrant as specified in its charter)

 

 

816.983.1303

(Registrant’s telephone number, including area code)

None

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

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

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 o     No þ

 

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 o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark 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.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

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

 

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

 

The aggregate market value of common stock held by non-affiliates of the registrant was $2.03 billion at June 30, 2006. There were 76,718,891 shares of $.01 par common stock outstanding at February 15, 2007.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Kansas City Southern’s Definitive Proxy Statement for the 2007 Annual Meeting of Stockholders which will be filed no later than 120 days after December 31, 2006, is incorporated by reference in Parts I and III.

 

 

KANSAS CITY SOUTHERN
2006 FORM 10-K ANNUAL REPORT

 

Table of Contents

 

 

COMPANY OVERVIEW

 

Kansas City Southern (“KCS” or the “Company”), 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. KCS and its subsidiaries had approximately 6,470 employees on December 31, 2006. The Kansas City Southern Railway Company (“KCSR”), which was founded in 1887, is a U.S. Class I railroad. 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. de R.L. de C.V. (“KCSM”), through its wholly owned subsidiary, Grupo KCSM, S.A. de C.V. (“Grupo KCSM”), formerly known as Grupo Transportación Ferroviaria Mexicana, S.A. de C.V., or Grupo TFM. Through its 50-year Concession from the Mexican government (“the Concession”), KCSM operates a primary commercial corridor of the Mexican railroad system and has as its core route a key portion of the shortest, most direct rail passageway between Mexico City and Laredo, Texas. KCSM serves most of Mexico’s principal industrial cities and three of its major shipping ports. KCSM’s rail lines are the only ones that serve Nuevo Laredo, Mexico, the largest rail freight interchange point between the United States and Mexico. Under the Concession, KCSM has the right to control 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 wholly owns, directly and indirectly, through its wholly-owned subsidiaries, Mexrail, Inc. (“Mexrail”) which, in turn, wholly owns The Texas Mexican Railway Company (“Tex-Mex”). Tex-Mex operates 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. Tex-Mex connects with KCSM at the United States/Mexico border at Laredo, Texas, and connects to KCSR through trackage rights at Beaumont, Texas. Through its ownership of Mexrail, the Company owns the northern half of the rail bridge at Laredo, Texas. Laredo is a principal international gateway through which more than half of all rail and truck traffic between the United States and Mexico crosses the border.

 

The KCS rail network (KCSR, KCSM and Tex-Mex) comprises approximately 6,000 miles of main and branch lines extending from the Midwest and Southeast portions of the United States south into Mexico and connects with 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 less congested interchange hubs.

 

KCS also owns a fifty percent equity investment in the stock of Panama Canal Railway Company (“PCRC”), which holds the concession to operate a 47-mile coast-to-coast railroad located adjacent to the Panama Canal. The railroad handles containers in freight service across the Isthmus of Panama. Panarail Tourism Company (“Panarail”), a wholly owned subsidiary of PCRC, operates commuter and tourist railway services over the lines of PCRC.

 

Other subsidiaries and affiliates of KCS include the following:

 

 

 

forest products made from trees in this region are generally less expensive than those from other regions due to lower production costs. As a result, southern yellow pine products from the Southeast are increasingly being used at the expense of western producers that have experienced capacity reductions because of public policy considerations. KCSR serves paper mills directly and indirectly through short-line connections.

 

This product category includes metals, minerals and ores such as iron, steel, zinc and copper. The majority of metals, minerals and ores mined, and steel produced in Mexico are used for domestic consumption. The volume of Mexican steel exports fluctuates based on global market prices. Higher-end finished products such as steel coils used by Mexican manufacturers in automobiles, household appliances and other consumer goods are imported through Nuevo Laredo and through the seaports served by KCS’ rail lines. United States slab steel products are used primarily in the manufacture of drill pipe for the oil industry.

 

Agricultural and Mineral.  Agricultural products consist of grain, food and related products. Shipper demand for agricultural 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’ rail lines receive and originate shipments of grain and grain products for delivery to feed mills serving the poultry industry. KCS currently serves feed mills along its rail lines throughout Arkansas, Oklahoma, Texas, Louisiana, Mississippi and Alabama. Through its marketing agreements, KCS has access to sources of corn and other grain in Iowa and other Midwest states. United States export grain shipments and Mexico import grain shipments include primarily corn, wheat, and soybeans transported to Mexico via Laredo and to the Gulf of Mexico for overseas destinations. Over the long term, export grain shipments to Mexico are expected to increase as a result of Mexico’s reliance on grain imports. Food and related products consist mainly of soybean meal, grain meal, oils and canned goods, sugar and beer. Mineral shipments consist of a variety of products including ores, clay, stone and cement.

 

Intermodal and Automotive.  The intermodal freight business consists primarily of hauling freight containers or truck trailers from motor carriers and ocean liners, with rail carriers serving as long-distance haulers. The automotive business consists primarily of moving parts to assembly plants and finished vehicles to distribution centers for market consumption in North and South America.

 

Coal.  KCS hauls unit trains of coal for ten electric generating plants in the central United States from the Powder River Basin in Wyoming. Coal mined in the Midwest United States is transported in non-unit trains to industrial consumers such as paper mills and cement companies.

 

GOVERNMENT REGULATION

 

The Company’s United States operations are subject to federal, state and local laws and regulations generally applicable to all businesses. Rail operations are subject to the regulatory jurisdiction of the Surface Transportation Board (“STB”) of the U.S. Department of Transportation (“DOT”), the Federal Railroad Administration of the 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. State agencies regulate some aspects of rail operations with respect to health and safety in areas not otherwise regulated by federal law.

 

KCS’ subsidiaries, as well as its competitors, 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 Secretary of Communications and Transportation (“SCT”). The SCT establishes regulations concerning railway safety and operations, and it is responsible for resolving disputes between railways and between railways and customers. In addition, KCSM must register its maximum rates with the SCT and make regular reports to the SCT on investment and traffic volumes.

 

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

 

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 the termination of the Concession. KCS believes that all facilities that it operates are in substantial compliance with applicable environmental laws, regulations and agency agreements. There are currently no material legal or administrative proceedings pending against the Company with respect to any environmental matters and management does not believe that continued compliance with environmental laws will have any material adverse effect on the Company’s financial condition or results of operations. KCS cannot predict the effect, if any, that the adoption of additional or more stringent environmental laws and regulations would have on the Company’s results of operations, cash flows or financial condition.

 

COMPETITION

 

The Company competes against other railroads, many of which are much larger and have significantly greater financial and other resources. Since 1994, there has been significant consolidation among major North American rail carriers. As a result, the railroad industry is now dominated by a few very large carriers.

The larger western railroads (BNSF Railway Company and Union Pacific Railroad Company), in particular, are significant competitors to KCS because of their substantial resources. The ongoing impact of these mergers is uncertain. KCS believes that its investments and strategic alliances continue to position the Company to attract additional rail traffic throughout its rail network.

 

In November 2005, Ferrocarril Mexicano, S.A. de C.V. (“Ferromex”) acquired control of and merged with Ferrocarril del Sureste, S.A. de C.V. (“Ferrosur”), creating Mexico’s largest railway. The merger between Ferromex and Ferrosur has been declared illegal by the Mexican Antitrust Commission. Both Ferromex and Ferrosur have challenged this ruling. These merged operations are much larger than KCSM, and they serve most of the major ports and cities in Mexico and own fifty percent of FTVM, which serves all of the industries located within Mexico City.

 

The Company is subject to competition from motor carriers, barge lines and other maritime shipping, which compete across certain routes in operating areas. Truck carriers have 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 and each other to provide end-to-end transportation of products.

 

While deregulation of freight rates has enhanced the ability of railroads to compete with each other and with alternative modes of transportation, this increased competition has resulted in downward pressure on freight rates. 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.

 

EMPLOYEES AND LABOR RELATIONS

 

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. Typically, neither management nor labor employees are permitted to take economic action until extended procedures are exhausted. Previously, these negotiations have not resulted in any extended work interruptions. Under the negotiating process which began on November 1, 1999, all unions reached new labor agreements with KCSR in 2005. Various collective bargaining agreements cover 81% of KCSR’s employees.

 

KCSM’s labor agreement covering approximately 75% of its employees was renewed in 2005 and is effective for a two-year term ending in July 2007. The compensation terms of the labor agreement are subject to renegotiation on an annual basis and all other terms are renegotiated every two years. These negotiations have not resulted in any strikes, boycotts or other significant disruptions of KCSM’s operations.

 

The response to Item 101 of Regulation S-K under Part II Item 7 of this Form 10-K, and the responses under Note 1 and Note 11 to the Consolidated Financial Statements in Item 8 of this Form 10-K are incorporated by reference in partial response to this Item 1. Refer to Item 2, “Properties”, for further discussion of the Company’s business.

 

AVAILABLE INFORMATION

 

KCS’ website (www.kcsouthern.com) provides at no cost the 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 electronic filing of these reports with the Securities and Exchange Commission. In addition, corporate governance guidelines, ethics and legal compliance policy, and the charters of the Audit Committee, the Finance Committee, the Nominating and Corporate Governance Committee and the Compensation and Organization Committee of the Board of Directors are available on the website. These guidelines, policies and charters are available in print without charge to any stockholder requesting them. Written requests 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).

 

Risks Related to an Investment in KCS’ Common Stock

 

The price of KCS’ common stock may fluctuate significantly, which may make it difficult for investors to resell common stock when they want to or at prices they find attractive.

 

The price of KCS’ common stock on the New York Stock Exchange (“NYSE”) constantly changes. The Company expects that the market price of its common stock will continue to fluctuate.

 

The Company’s stock price can fluctuate as a result of a variety of factors, many of which are beyond KCS’ control. These factors include, but are not limited to:

 

 

In addition, from time to time the stock market in general has experienced extreme volatility that has often been unrelated to the operating performance of a particular company. These broad market fluctuations may adversely affect the market price of KCS’ common stock.

 

KCS’ ability to pay dividends on its common stock is currently restricted, and KCS does not anticipate paying cash dividends on its common stock in the foreseeable future.

 

KCS has agreed, and may agree in the future, to restrictions on its ability to pay dividends on its common stock. In addition, to maintain its credit ratings, the Company may be limited in its ability to pay dividends on its common stock so that it can maintain an appropriate level of debt. During the first quarter of 2000, the board of directors suspended common stock dividends. KCS does not anticipate making any cash dividend payments to its common stockholders for the foreseeable future.

 

Holders of the Series C Preferred Stock and Series D Preferred Stock may have special voting rights if KCS fails to pay dividends on that preferred stock over a stated number of quarters.

 

Because of certain restrictions in the indentures governing notes issued by KCSR, KCS did not pay dividends on its Series C Preferred Stock or Series D Preferred Stock commencing on May 15, 2006, for the first quarter of 2006 until those dividend arrearages were made up in February 2007. If dividends on the Series C Preferred Stock or Series D Preferred Stock are in arrears for six consecutive quarters (or an equivalent number of days in the aggregate, whether or not consecutive) holders of the Series C Preferred Stock or Series D Preferred Stock, as applicable, will be entitled to elect two of the authorized number of directors at the next annual stockholders’ meeting at which directors are elected and at each subsequent stockholders’ meeting until such time as all accumulated dividends are paid on the Series C Preferred Stock or

Series D Preferred Stock, as applicable, or set aside for payment. In addition, KCS will not be eligible to register future offerings of securities on Form S-3 or to avail itself of the other benefits available to companies that qualify as “well-known seasoned issuers” under SEC rules if KCS fails to pay dividends on its preferred stock. This could adversely affect KCS’ ability to access capital markets, and increase the cost of accessing capital markets, until the Company qualifies as a “well-known seasoned issuer.”

 

Sales of substantial amounts of KCS’ common stock in the public market could adversely affect the prevailing market price of the common stock.

 

As of December 31, 2006, there were 10,607,068 shares of common stock issued or reserved for issuance under the 1991 Amended and Restated Stock Option and Performance Award Plan and the Employee Stock Purchase Plan, 2,061,234 shares of common stock held by executive officers and directors outside those plans, and 20,389,113 shares of common stock reserved for issuance upon conversion of the outstanding shares of convertible preferred stock. Sales of common stock by employees upon exercise of their options, sales by executive officers and directors subject to compliance with Rule 144 under the Securities Act, and sales of common stock that may be issued upon conversion of the outstanding preferred stock, or the perception that such sales could occur, may adversely affect the market price of KCS’ common stock.

 

KCS has provisions in its charter, bylaws and Rights Agreement that could deter, delay or prevent a third party from acquiring KCS and that could deprive an investor of an opportunity to obtain a takeover premium for shares of KCS’ common stock.

 

KCS has provisions in its charter and bylaws that may delay or prevent unsolicited takeover bids from third parties. These provisions may deprive KCS’ stockholders of an opportunity to sell their shares at a premium over prevailing market prices. For example, the restated certificate of incorporation provides for a classified board of directors. It further provides that the vote of 70% of the shares entitled to vote in the election of directors is required to amend the restated certificate of incorporation to increase the number of directors to more than eighteen, abolish cumulative voting for directors and abolish the classification of the board. The same vote requirement is imposed by the restated certificate of incorporation on certain transactions involving mergers, consolidations, sales or leases of assets with or to certain owners of more than 5% of KCS’ outstanding stock entitled to vote in the election of directors. The bylaws provide that a stockholder must give the Company advance written notice of its intent to nominate a director or raise a matter at an annual meeting. In addition, the Company has adopted a Rights Agreement which under certain circumstances would significantly impair the ability of third parties to acquire control of KCS without prior approval of the board of directors.

 

Risks Related to KCS’ Business

 

KCS competes against other railroads and other transportation providers.

 

The Company’s domestic and international operations are subject to competition from other railroads, in particular the Union Pacific Railroad Company (“UP”) and BNSF Railway Company (“BNSF”) in the United States and Ferromex in Mexico. Many of KCS’ rail competitors are much larger and have significantly greater financial and other resources than KCS. In addition, the Company is subject to competition from truck carriers and from barge lines and other maritime shipping. Increased competition could result in downward pressure on freight rates. 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. While KCS must build or acquire and maintain its infrastructure, truck carriers, maritime shippers and barges are able to use public rights-of-way. The trucking industry has in the past provided effective rate and service competition to the railroad industry. Trucking requires substantially smaller capital investment and maintenance expenditures than railroads and allows for more frequent and flexible scheduling. Continuing competitive pressures, any reduction in margins due to competitive pressures, future improvements that increase the quality 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 have a material adverse effect on results of operations, financial condition and liquidity.

 

A material part of KCS’ growth strategy is based upon the conversion of truck traffic to rail. There can be no assurance the Company will have the ability to convert traffic from truck to rail transport or that the customers already converted will be retained. If the railroad industry in general, and the Mexican operations in particular, are unable to preserve their competitive advantages vis-à-vis the trucking industry, projected revenue growth from the Mexican operations could be adversely affected. Additionally, the revenue growth attributable to the Mexican operations could be affected by, among other factors, KCS’ inability to grow its existing customer base, negative macroeconomic developments impacting the United States or Mexican economies, and failure to capture additional cargo transport market share from the shipping industry and other railroads.

 

NAFTA called for Mexican trucks to have unrestricted access to highways in United States border states by 1995 and full access to all United States highways by January 2000. However, the United States did not follow that timetable because of concerns over Mexico’s trucking safety standards. In February 2001, a NAFTA tribunal ruled in an arbitration between the United States and Mexico that the United States must allow Mexican trucks to cross the border and operate on United States highways. On March 14, 2002, as part of its agreement under NAFTA, the U.S. Department of Transportation issued safety rules that allow Mexican truckers to apply for operating authority to transport goods beyond the 20-mile commercial zones along the United States-Mexico border. These safety rules require Mexican motor carriers seeking to operate in the United States to, among other things, pass safety inspections, obtain valid insurance with a United States registered insurance company, conduct alcohol and drug testing for drivers and obtain a U.S. Department of Transportation identification number. Under the rules issued by the U.S. Department of Transportation, it was expected that the border would have been opened to Mexican motor carriers in 2002. However, in January 2003, in response to a lawsuit filed in May 2002 by a coalition of environmental, consumer and labor groups, the U.S. Court of Appeals for the Ninth Circuit issued a ruling which held that the rules issued by the U.S. Department of Transportation violated federal environmental laws because the Department of Transportation failed to adequately review the impact on United States air quality of rules allowing Mexican carriers to transport beyond the 20-mile commercial zones along the United States-Mexico border. The Court of Appeals ruling required the Department of Transportation to provide an Environmental Impact Statement on the Mexican truck plan and to certify compliance with the United States Clean Air Act. The Department of Transportation requested the United States Supreme Court to review the Court of Appeals ruling and, on December 15, 2003, the Supreme Court granted the Department of Transportation’s request. On June 7, 2004, the Supreme Court unanimously overturned the Court of Appeals ruling. Although the Department of Transportation is no longer required to provide an Environmental Impact Statement under the Supreme Court’s ruling, the United States and Mexico must still complete negotiations on safety inspections before the border is opened. KCS cannot predict when these negotiations will be completed. There can be no assurance that truck transport between Mexico and the United States will not increase substantially in the future if the United States and Mexico complete the negotiations and the border is opened. Any such increase in truck traffic could affect KCS’ ability to continue converting traffic to rail from truck transport because it may result in an expansion in the availability, or an improvement in the quality, of the trucking services offered by Mexican carriers.

 

Through KCSM’s Concession from the Mexican government, the Company has the right to control and operate the southern half of the rail-bridge at Laredo, Texas. Under the Concession, KCSM must grant to Ferromex the right to operate over a north-south portion of KCSM’s rail lines between Ramos Arizpe near Monterrey and the city of Queretaro that constitutes over 600 kilometers (360 miles) of KCSM’s main track. Using these trackage rights, Ferromex may be able to compete with KCSM over KCSM’s rail lines for traffic between Mexico City and the United States. The Concession also requires KCSM to grant rights to use certain portions of its tracks to Ferrosur and the “belt railroad” operated in the greater Mexico City area by FTVM, thereby providing Ferrosur with more efficient access to certain Mexico City industries. As a result of having to grant trackage rights to other railroads, KCSM loses the capacity of using a portion of its tracks at all times.

 

Ferromex, the operator of the largest railway system in Mexico, is in close proximity to KCSM’s rail lines. In particular, KCSM has experienced and continues to experience competition from Ferromex with respect to the transport of a variety of products. The rail lines operated by Ferromex run from Guadalajara and Mexico City to four United States border crossings west of the Nuevo Laredo-Laredo crossing, providing an alternative to KCSM’s routes for the transport of freight from those cities to the United States border. In addition, Ferromex directly competes with KCSM in some areas of its service territory, including Tampico, Saltillo, Monterrey and Mexico City. Ferrosur competes directly with KCSM for traffic to and from southeastern Mexico. Ferrosur, like KCSM, also services Mexico City and Puebla.

 

In November 2005, Grupo México, the controlling shareholder of Ferromex, acquired all of the shares of Ferrosur. The common control of Ferromex and Ferrosur would give Grupo México control over a nationwide railway system in Mexico and ownership of 50% of the shares of FTVM. The merger between Ferromex and Ferrosur has been declared illegal by the Mexican Antitrust Commission. Both Ferromex and Ferrosur have challenged this ruling. There can be no assurance as to whether Grupo México will be successful in challenging this ruling. If Grupo México is successful in its appeal, KCSM’s competitive position may be harmed.

 

On August 3, 2006, the Mexican Antitrust Commission announced an investigation into possible antitrust practices in the provision of rail cargo services. The targets of that investigation have not been identified, and while KCSM may be required to provide information in connection with the investigation, the Company does not believe KCSM’s operations are the subject of the inquiry, although there can be no assurance KCSM is not or would not become a subject of the inquiry.

 

Rate reductions by competitors could make KCS’ freight services less competitive, and KCS cannot assure that it would always be able to match these rate reductions. In recent years, KCS has experienced aggressive price competition from Ferromex in freight rates for agricultural products, which has adversely affected results of operations. KCS’ ability to respond to competitive pressures by decreasing rates without adversely affecting gross margins and operating results will depend on, among other things, the ability to reduce operating costs. KCS’ failure to respond to competitive pressures, and particularly rate competition, in a timely manner could have a material adverse effect on the Company’s financial condition.

 

In recent years, there has also been significant consolidation among major North American rail carriers. The resulting merged railroads could attempt to use their size and pricing power to block other railroads’ access to efficient gateways and routing options that are currently and have been historically available. There can be no assurance that further consolidation in the railroad industry, whether in the United States or Mexico, will not have an adverse effect on operations.

 

KCS’ business strategy, operations and growth rely significantly on agreements with other railroads and third parties.

 

Operation of KCS’ integrated 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. KCS’ operations are dependent on 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’ 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. The termination of, or the failure to renew, these agreements could adversely affect KCS’ business, financial condition and results of operations. KCS is also dependent in part upon the financial health and efficient performance of other railroads. For example, traffic moves over the UP’s lines via trackage rights, a significant portion of KCSR’s grain shipments originate with another rail carrier pursuant to marketing agreements with that carrier, and BNSF is KCS’ largest partner in the interchange of rail traffic. There can be no assurance that KCS will not be materially adversely affected by operational or financial difficulties of other railroads.

 

Pursuant to the Concession, KCSM is required to grant rights to use portions of its tracks to Ferromex, Ferrosur and FTVM. Applicable law stipulates that Ferromex, Ferrosur and FTVM are required to grant to KCSM rights to use portions of their tracks. KCSM’s Concession classifies trackage rights as short trackage

rights and long-distance trackage rights. Although all of these trackage rights have been granted under the Concession, no railroad has actually operated under the long-distance trackage rights because the means of setting rates for usage and often related terms of usage have not been agreed upon. Under the Mexican railroad services law and regulations, the rates KCSM may charge for the right to use its tracks must be agreed upon in writing between KCSM and the party to which those rights are granted. However, if KCSM cannot reach an agreement on rates with rail carriers entitled to trackage rights on KCSM’s rail lines, the SCT is entitled to set the rates in accordance with Mexican law and regulation, which rates may not adequately compensate KCSM. KCSM and Ferromex have not been able to agree upon the rates each of them is required to pay the other for interline services and haulage and trackage rights. KCSM and Ferromex are involved in civil, commercial and administrative proceedings in connection with amounts payable to each other for interline services, haulage and trackage rights. On March 13, 2002, the SCT issued a ruling setting the rates for trackage and haulage rights. On August 5, 2002, the SCT issued a ruling setting the rates for interline and terminal services. KCSM and Ferromex appealed both rulings to the Mexican Supreme Court. KCSM and Ferromex also requested and obtained a suspension of the effectiveness of the SCT rulings pending resolution of the litigation. In February 2006, the Mexican Supreme Court sustained KCSM’s appeal of the SCT’s trackage and haulage rights ruling, vacated the SCT ruling and ordered the SCT to issue a new ruling consistent with the Court’s opinion. The Company has not yet received the written opinion of the Mexican Supreme Court on the February 2006 ruling, nor has the Court decided the interline and terminal services appeal. On October 2, 2006, KCSM was served with a claim by Ferromex asking for information concerning the interline traffic between KCSM and Ferromex from January 1, 2002, to December 31, 2004. KCSM has filed an answer to this claim. KCS cannot predict the ultimate outcome of these matters, or whether the rates KCSM is ultimately permitted to charge will be sufficient to adequately compensate it for the use of its tracks by Ferromex.

 

The Company is highly leveraged and has significant debt service obligations. KCS’ leverage could adversely affect its ability to fulfill obligations under various debt instruments and operate its business.

 

KCS’ level of debt could make it more difficult for it to borrow money in the future, may reduce the amount of money available to finance operations and other business activities, exposes the Company to the risk of increased interest rates, makes it more vulnerable to general economic downturns and adverse industry conditions, and could reduce flexibility in planning for, or responding to, changing business and economic conditions. KCS’ failure to comply with the financial and other restrictive covenants in its debt instruments, which, among other things, require KCS to maintain specified financial ratios and limit the ability to incur debt and sell assets, could result in an event of default that, if not cured or waived, could have a material adverse effect on business or prospects. If the Company does not have enough cash to service its debt, meet other obligations and fund other liquidity needs, KCS may be required to take actions such as reducing or delaying capital expenditures, selling assets, restructuring or refinancing all or part of the existing debt, or seeking additional equity capital. KCS cannot assure that any of these remedies, including obtaining appropriate waivers from its lenders, can be effected on commercially reasonable terms or at all. In addition, the terms of existing or future debt agreements may restrict the Company from adopting any of these alternatives.

 

The indebtedness of KCSM exposes it to risks of exchange rate fluctuations, because any devaluation of the peso would cause the cost of KCSM’s dollar-denominated debt to increase, and could place the Company at a competitive disadvantage in Mexico compared to Mexican competitors that have less debt and greater operating and financing flexibility than KCSM does.

 

KCS’ business is capital intensive.

 

The Company’s business is capital intensive and requires substantial ongoing expenditures for, among other things, additions and improvements to roadway, structures and technology, acquisitions, and maintenance and repair of equipment and rail system. KCS’ failure to make necessary capital expenditures to maintain its operations could impair its ability to serve existing customers or accommodate increases in traffic volumes.

 

KCS has funded, and expects to continue to fund, capital expenditures with funds from operating cash flows, leases and, to a lesser extent, vendor financing. KCS may not be able to generate sufficient cash flows from its operations or obtain sufficient funds from external sources to fund capital expenditure requirements. If financing is available, it may not be obtainable on acceptable terms and within the limitations contained in the indentures and other agreements relating to KCS’ debt.

 

KCSM’s Concession from the Mexican government requires KCSM to make investments and undertake capital projects. If KCSM is unable to make such capital investments, KCSM’s business plan commitments with the Mexican government may be at risk, requiring KCSM to seek waivers of its business plan. There is no assurance that such waivers, if requested, would be granted by the SCT. KCSM may defer capital expenditures under its business plan with the permission of the SCT. However, the SCT might not grant this permission, and any failure by KCSM to comply with the capital investment commitments in its business plan could result in sanctions imposed by the SCT. The Company cannot assure that the Mexican government would grant any such permission or waiver. If such permission or waiver is not obtained in any instance and KCSM is sanctioned, its Concession might be at risk of revocation, which would adversely affect KCS’ financial condition and results of operations. See “KCSM’s Mexican Concession is subject to revocation or termination in certain circumstances” below.

 

KCS’ business may be adversely affected by changes in general economic, weather or other conditions.

 

KCS’ operations may be 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 affect the businesses served by KCS. PCRC and Panarail are directly affected by the Panamanian local economy and trans-Pacific trade flows. KCS’ investments in Mexico and Panama expose the Company to risks associated with operating in Mexico and Panama, including, among others, cultural differences, varying labor and operating practices, political risk and differences between the United States, Mexican and Panamanian economies. Historically, a stronger economy has resulted in improved results for KCS’ rail transportation operations. Conversely, when the economy has slowed, results have been less favorable. KCS’ revenues may be affected by prevailing economic conditions and, if an economic slowdown or recession occurs in key markets, the volume of rail shipments is likely to be reduced.

 

The Company’s operations may also be affected by natural disasters or adverse weather conditions. The Company operates in and along the Gulf Coast of the United States, and its facilities may be adversely affected by hurricanes and other extreme weather conditions. For example, hurricanes have adversely affected some of the Company’s shippers located along the Gulf Coast and caused interruptions in the flow of traffic within the southern United States and between the United States and Mexico. As another example, a weak harvest in the Midwest may substantially reduce the volume of business handled for agricultural products customers. Many of the goods and commodities transported experience cyclical demand. KCS’ results of operations can be expected to reflect this cyclical demand because of the significant fixed costs inherent in railroad operations. Significant reductions in the volume of rail shipments due to economic, weather or other conditions could have a material adverse effect on KCS’ business, financial condition, results of operations and cash flows.

 

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 segment that may influence operating results. Some of KCS’ customers do business in industries that are highly cyclical, including the oil and gas, automotive, housing and agricultural industries. Any downturn 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. For example, global steel and petrochemical prices have decreased in the past. KCS cannot assure that prices and demand for these products will not decline in the future, adversely affecting those industries and, in turn, the Company’s financial condition or results.

 

KCS’ business is subject to regulation by international, federal, state and local regulatory agencies. KCS’ failure to comply with these regulations could have a material adverse effect on its operations.

 

KCS is subject to governmental regulation by international, federal, state and local regulatory agencies with respect to its railroad operations, as well as a variety of health, safety, labor, environmental, and other matters. Government regulation of the railroad industry is a significant determinant of the competitiveness and profitability of railroads. KCS’ failure to comply with applicable laws and regulations could have a material adverse effect on operations, including limitations on operating activities until compliance with applicable requirements is achieved. These government agencies may change the legislative or regulatory framework within which the Company operates without providing any recourse for any adverse effects on its 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, and KCS cannot assure that it will continue to be able to do so.

 

The Company’s business is subject to environmental, health and safety laws and regulations that could require KCS to incur material costs or liabilities relating to environmental, health or safety compliance or remediation.

 

KCS’ operations are subject to extensive international, federal, state and local environmental, health and safety laws and regulations concerning, among other things, emissions to the air, discharges to waters, the handling, storage, transportation and disposal of waste and other materials, the cleanup of hazardous material or petroleum releases, decommissioning of underground storage tanks and noise pollution. Violations of these laws and regulations can result in substantial penalties, permit revocations, facility shutdowns and other civil and criminal sanctions. From time to time, certain of KCS’ facilities have not been in compliance with environmental, health and safety laws and regulations and there can be no assurances that KCS will always be in compliance with such laws and regulations in the future. 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. New laws and regulations, stricter enforcement of existing requirements, new spills, releases or violations or the discovery of previously unknown contamination could require KCS to incur costs or become the basis for new or increased liabilities that could have a material adverse effect on KCS’ business, results of operations, financial condition and cash flows.

 

In the operation of a railroad, it is possible that derailments, explosions or other accidents may occur that could cause harm to the environment or to human life or health. As a result, KCS may incur costs in the future, which may be material, to address any such harm, including costs relating to the performance of clean-ups, natural resources damages and compensatory or punitive damages relating to harm to property or individuals.

 

The U.S. Comprehensive Environmental Response, Compensation and Liability Act (“CERCLA” or “Superfund”) and similar state laws (known as “Superfund laws”) impose liability for the cost of remedial or removal actions, natural resources damages and related costs at certain sites identified as posing a threat to the environment or public health. CERCLA imposes joint, strict and several liability on the owners and operators of facilities in which hazardous waste and other hazardous substances are deposited or from which they are released or are likely to be released into the environment. Liability may be imposed, without regard to fault or the legality of the activity, on certain classes of persons, including the current and certain prior owners or operators of a site where hazardous substances have been released and persons that arranged for the disposal or treatment of hazardous substances. In addition, other potentially responsible parties, adjacent landowners or other third parties may initiate cost recovery actions or toxic tort litigation against sites subject to CERCLA or similar state laws. Given the nature of its business, KCS presently has environmental investigation and remediation obligations at certain sites, including a former foundry site in Alexandria, Louisiana, and will likely incur such obligations at additional sites in the future. Liabilities accrued for environmental costs represent the Company’s best estimate of the probable future obligation for the remediation and settlement of these sites. Although the recorded liability includes the best estimate of all probable costs, clean-up costs can not be predicted with any certainty 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 Mexican operations are subject to Mexican federal and state laws and regulations relating to the protection of the environment. The primary environmental law in Mexico is the General Law of Ecological Balance and Environmental Protection (the “Ecological Law”). The Mexican federal agency in charge of overseeing compliance with and enforcement of the federal environmental law is the Ministry of Environmental Protection and Natural Resources (“Semarnat”). The regulations issued under the Ecological Law and technical environmental requirements issued by Semarnat have promulgated standards for, among other things, water discharge, water supply, emissions, noise pollution, hazardous substances and transportation and handling of hazardous and solid waste. As part of its enforcement powers, Semarnat is empowered to bring administrative and criminal proceedings and impose economic sanctions against companies that violate environmental laws, and temporarily or even permanently close non-complying facilities. KCSM is also subject to the laws of various jurisdictions and international conferences 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. The Company cannot predict the effect, if any, that the adoption of additional or more stringent environmental laws and regulations would have on KCSM’s results of operations, cash flows or financial condition.

 

KCS’ business is vulnerable to rising fuel costs and disruptions in fuel supplies. Any significant increase in the cost of fuel, or severe disruption of fuel supplies, would have a material adverse effect on KCS’ business, results of operations and financial condition.

 

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. Fuel expense increased from 16% of consolidated operating costs during 2005 to 19% of consolidated operating costs during 2006. KCS has been able to pass the majority of these fuel cost increases on to customers in the form of fuel surcharges applied to customer billings. If KCS is unable to continue the existing fuel surcharge program for KCSR and expand the fuel surcharge program for KCSM, operating results could be materially adversely affected.

 

On January 26, 2007, the Surface Transportation Board (the “STB”) issued a decision finding that the assessment by railroads of fuel surcharges that are based on a percentage of the base rate charged is an unreasonable practice. Railroads have 90 days following January 26 to comply with the decision. KCS is in the process of reviewing the manner by which it assesses fuel surcharges in order to timely comply with the decision. KCS cannot predict with certainty the impact that any changes to its fuel surcharge program may have on its business.

 

Fuel costs are affected by traffic levels, efficiency of operations and equipment, and petroleum market conditions. The supply and cost of fuel are subject to market conditions and are influenced by numerous factors beyond the Company’s control, including general economic conditions, world markets, government programs and regulations and competition. In addition, instability in the Middle East and interruptions in domestic production and refining due to hurricane damage may result in an increase in fuel prices. Fuel prices and supplies could also be affected by any limitation in the fuel supply or by any imposition of mandatory allocation or rationing regulations. In the event of a severe disruption of fuel supplies resulting from supply shortages, political unrest, a disruption of oil imports, weather events, war or otherwise, the resulting impact on fuel prices could materially adversely affect KCS’ operating results, financial condition and cash flows.

 

KCS currently meets, and expects to continue to meet, fuel requirements for its Mexican operations almost exclusively through purchases at market prices from Petroleos Mexicanos, the national oil company of Mexico (“PEMEX”), a government-owned entity exclusively responsible for the distribution and sale of diesel fuel in Mexico. KCSM is party to a fuel supply contract with PEMEX of indefinite duration. Either party may terminate the contract upon 30 days written notice to the other at any time. If the fuel contract is terminated

and KCSM is unable to acquire diesel fuel from alternate sources on acceptable terms, the Mexican operations could be materially adversely affected.

 

The loss of key personnel could negatively affect business.

 

KCS’ success substantially depends on its ability to attract and retain key members of the senior management team and the principals of its foreign subsidiaries. Recruiting, motivating and retaining qualified management personnel, particularly those with expertise in the railroad industry, are vital to operations and success. There is substantial competition for qualified management personnel and there can be no assurance that KCS will always be able to attract or retain qualified personnel. Employment agreements with senior management are terminable at any time by either party. If KCS loses one or more of these key executives or principals, its ability to successfully implement its business plans and the value of its common stock could be materially adversely affected.

 

A majority of KCS’ 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, 2006, approximately 81% of KCSR employees and approximately 75% of KCSM employees were covered by collective labor contracts. 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’ 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’ control. KCS may, therefore, be subject to terms and conditions in industry-wide labor agreements that could have a material adverse affect on its results of operations, financial position and cash flows. 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 faces possible catastrophic loss and liability, and its insurance may not be sufficient to cover its damages or damages to others.

 

The operation of any railroad carries with it an inherent risk of catastrophe, mechanical failure, collision and property loss. In the course of KCS’ operations, spills or other environmental mishaps, cargo loss or damage, business interruption due to political developments, as well as labor disputes, strikes and adverse weather conditions, could result in a loss of revenues or increased liabilities and costs. Collisions, environmental mishaps or other accidents can cause serious bodily injury, death and extensive property damage, particularly when such accidents occur in heavily populated areas. Additionally, KCS’ operations may be affected from time to time by natural disasters such as earthquakes, volcanoes, floods, hurricanes or other storms. The occurrence of a major natural disaster could have a material adverse effect on KCS’ operations and financial condition. The Company maintains insurance that is consistent with industry practice against the accident-related risks involved in the conduct of its business and business interruption due to natural disaster. However, this insurance is subject to a number of limitations on coverage, depending on the nature of the risk insured against. This insurance may not be sufficient to cover KCS’ damages or damages to others, and this insurance may not continue to be available at commercially reasonable rates. Even with insurance, if any catastrophic interruption of service occurs, KCS may not be able to restore service without a significant interruption to operations and an adverse effect on KCS’ financial condition.

 

KCS’ business may be affected by future acts of terrorism or war.

 

Terrorist attacks, such as an attack on the Company’s chemical transportation activities, any government response thereto and war or risk of war may adversely affect KCS’ results of operations, financial condition, and cash flows. These acts may also impact the Company’s ability to raise capital or its future business opportunities. KCS’ rail lines and facilities could be direct targets or indirect casualties of acts of terror, which could cause significant business interruption and result in increased costs and liabilities and decreased revenues. These acts could have a material adverse effect on KCS’ results of operations, financial condition, and cash flows. In addition, insurance premiums charged for some or all of the terrorism coverage currently maintained by KCS could increase dramatically or certain coverage may not be available in the future.

 

KCSM’s Mexican Concession is subject to revocation or termination in certain circumstances.

 

KCSM operates under a 50-year Concession granted by the Mexican government. The Concession gives KCSM exclusive rights to provide freight transportation services over its rail lines for 30 years of the 50-year Concession, subject to certain trackage rights. The SCT is principally responsible for regulating railroad services in Mexico. The SCT has broad powers to monitor KCSM’s compliance with the Concession and it can require KCSM to supply it with any technical, administrative and financial information it requests. 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 five years. The SCT treats KCSM’s business plans confidentially. The SCT monitors KCSM’s compliance with efficiency and safety standards established in the Concession. The SCT reviews, and may amend, these standards every five years.

 

The Mexican railroad services law and regulations provide the Mexican government certain rights in its relationship with KCSM under the Concession, including the right to take over the management of KCSM and its railroad in certain extraordinary cases, such as imminent danger to national security. In the past, the Mexican government has used such power with respect to other privatized industries, including the telecommunications industry, to ensure continued service during labor disputes. In addition, under the Concession and the Mexican railroad services law and regulations, the SCT, in consultation with the Mexican Antitrust Commission, reserves the right to set tariffs if it determines that effective competition does not exist. The Mexican Antitrust Commission, however, has not published guidelines regarding the factors that constitute a lack of competition. It is therefore unclear under what particular circumstances the Mexican Antitrust Commission would deem a lack of competition to exist. If the SCT intervenes and sets tariffs, the rates it sets may be too low to allow KCSM to operate profitably.

 

The Concession is renewable for up to 50 years, subject to certain conditions. The SCT may terminate the Concession if, among other things, there is an unjustified interruption in the operation of KCSM’s rail lines, KCSM charges tariffs higher than the tariffs it has registered with the SCT, KCSM restricts the ability of other Mexican rail operators to use its rail lines, KCSM fails to make payments for damages caused during the performance of services, KCSM fails to comply with any term or condition of the Mexican railroad services law and regulations, KCSM fails to make the capital investments required under its five-year business plan filed with the SCT, or KCSM fails to maintain an obligations compliance bond and insurance coverage as specified in the Mexican railroad services law and regulations. In addition, the Concession would revoke automatically if KCSM changes its nationality or assigns or creates any lien on the Concession 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, by revocation or upon KCSM’s liquidation or bankruptcy. Revocation or termination of the Concession would prevent KCSM from operating its railroad and would materially adversely affect the Mexican operations and the ability to make payments on KCSM’s debt. If the Concession is revoked by the SCT, KCSM would receive no revenue, 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.

 

In April 2006, the SCT initiated sanction proceedings against KCSM, claiming that KCSM had failed to make the minimum capital investments projected for 2004 and 2005 under its five-year business plan filed with the SCT. Although the Company believes KCSM made capital expenditures exceeding the amounts

projected in its business plan for 2004 and 2005, the SCT has objected to the nature of the investments made by KCSM. KCSM has responded to the SCT by providing evidence in support of its investments and explaining why it believes sanctions are not appropriate. The SCT has not yet responded to KCSM’s arguments. KCSM will have the right to challenge a negative ruling by the SCT before the Administrative Federal Court, and, if necessary, the right to challenge any negative ruling by the Administrative Federal Court before a Federal Magistrate’s Tribunal. However, if these proceedings are determined adversely to KCSM and sanctions are imposed, KCSM could be subject to fines, and could be subject to possible future revocation of the Concession if the SCT imposes sanctions on three additional occasions over the remaining term of the Concession.

 

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. 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 disturbances 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 railroad services 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 timely made.

 

The Company’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 the Mexican operations in particular. The national elections held on July 2, 2000, ended 71 years of rule by the Institutional Revolutionary Party and resulted in the increased representation of opposition parties in the Mexican Congress and in mayoral and gubernatorial positions. National elections were again held on July 2, 2006, which were disputed by the losing presidential candidate and his supporters. Although there have not yet been any material adverse repercussions resulting from this political change, multiparty rule is still relatively new in Mexico and could result in economic or political conditions that could materially and adversely affect the Mexican operations. KCS cannot predict the impact that this new political landscape will have on the Mexican economy. Furthermore, KCSM’s financial condition, results of operations and prospects may be affected by currency fluctuations, inflation, interest rates, regulation, taxation, social instability and other political, social and economic developments in or affecting Mexico.

 

Mexican national politicians are currently focused on certain regional political and social tension, and reforms regarding fiscal and labor policies, gas, electricity, social security and oil have not been and may not be approved. The social and political situation in Mexico could adversely affect the Mexican economy, which in turn could have a material adverse effect on KCS’ business, financial condition and results of operation.

 

The Mexican economy in the past has suffered balance of payment deficits and shortages in foreign exchange reserves. There are currently no exchange controls in Mexico. However, Mexico has imposed foreign exchange controls in the past. Pursuant to the provisions of NAFTA, if Mexico experiences serious balance of payment difficulties or the threat of such difficulties in the future, Mexico would have the right to impose foreign exchange controls on investments made in Mexico, including those made by United States and Canadian investors. Any restrictive exchange control policy could adversely affect KCS’ ability to obtain dollars or to convert pesos into dollars for purposes of making interest and principal payments due on indebtedness, to the extent KCS may have to effect those conversions, and could adversely affect the Mexican economy or the Company’s investment in KCSM. This could have a material adverse effect on KCS’ business and financial condition.

 

Securities of companies in emerging market countries tend to be influenced by economic and market conditions in other emerging market countries. Some emerging market countries, including Argentina and Brazil, have experienced significant economic downturns and market volatility in the past. These events have had an adverse effect on the economic conditions and securities markets of other emerging market countries, including Mexico.

 

Downturns in the United States economy or in trade between the United States and Mexico and fluctuations in the peso-dollar exchange rate would likely have adverse effects on KCS’ business and results of operations.

 

The level and timing of KCS’ Mexican business activity is heavily dependent upon the level of United States-Mexican trade and the effects of NAFTA 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. Downturns in the United States or Mexican economy or in trade between the United States and Mexico would likely have adverse effects on KCS’ business and results of operations. 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. Any future downturn in the United States economy could have a material adverse effect on KCS’ results of operations and our ability to meet debt service obligations.

 

Also, fluctuations in the peso-dollar exchange rate 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.

 

Any devaluation of the peso would cause the peso cost of KCSM’s dollar-denominated debt to increase, adversely affecting its ability to make payments on its indebtedness. Severe devaluation or depreciation of the peso 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 of the U.S. dollar-denominated debt and contractual commitments. Devaluation or depreciation of the peso against the U.S. dollar may also adversely affect U.S. dollar prices for KCS’ securities. Currency fluctuations are likely to continue to have an effect on KCS’ financial condition in future periods.

 

KCSM has identified possible discrepancies in data provided by its prior information system.

 

KCSM installed a new operational information system in 2006. Based on testing of the data provided by this system, including a comparison of such data to data provided by KCSM’s prior information system, it is possible that the data provided by KCSM’s prior information system may have contained discrepancies. There is uncertainty as to what effect, if any, these discrepancies could have on KCSM’s financial condition or results of operations, however there can be no assurance that the effect will not be material.

 

Mexico may experience high levels of inflation in the future which could adversely affect KCS’ results of operations.

 

Mexico has a history of high levels of inflation, and may experience high inflation in the future. During most of the 1980s and during the mid- and late-1990s, Mexico experienced periods of high levels of inflation. The annual rates of inflation for the last five years, as measured by changes in the National Consumer Price

Index, as provided by Banco de Mexico, were 4.0% in 2006, 3.3% in 2005, 5.2% in 2004, 4.0% in 2003 and 5.7% in 2002. A substantial increase in the Mexican inflation rate would have the effect of increasing some of KCSM’s costs, which could adversely affect its results of operations and financial condition. High levels of inflation may also affect the balance of trade between Mexico and the United States, and other countries, which could adversely affect KCSM’s results of operations.

 

None.

 

Property information is provided for each of KCS’ two business segments, the United States (“U.S.”) and Mexico.

 

U.S. Segment.

 

Certain KCSR property statistics follow at December 31:

 

 

KCSR and Mexrail’s fleet of locomotives and rolling stock consisted of the following at December 31:

 

 

 

KCSR, in support of its transportation operations, owns and operates repair shops, depots and office buildings along its right-of-way. A major facility, the Deramus Yard, is located in Shreveport, Louisiana and includes a general office building, locomotive repair shop, car repair shops, customer service center, material warehouses and fueling facilities totaling 227,000 square feet. Other facilities owned by KCSR include a 21,000 square foot freight car repair shop in Kansas City, Missouri and 15,000 square feet of office space in Baton Rouge, Louisiana. A locomotive repair facility in Kansas City is owned and operated by General

Electric Company (“GE”) and is used to maintain and repair locomotives that were manufactured by GE and are leased by KCSR.

 

KCSR owns 16.6% of the Kansas City Terminal Railway Company, which owns and operates 80 miles of track, and operates an additional eight miles of track under trackage rights in greater Kansas City, Missouri. KCSR also leases, for operating purposes, certain short sections of trackage owned by various other railroad companies and jointly owns certain other facilities with these railroads.

 

Mexico Segment.

 

Certain KCSM track statistics at December 31, 2006, follow (in miles):

 

 

All of KCSM’s track is standard gauge (56.5 inches) and is generally in good condition. Regarding the main track, 100% has 100 to 136-lbs. rail, 78% is continuously welded rail and 58% has concrete ties. Continuously welded rail reduces track maintenance and, in general, permits trains to travel at higher speeds. The Mexico City — Nuevo Laredo core route has 88% concrete ties and the portion of this route between Mexico City and Querétaro (a distance of 143 miles) has double track. KCSM has extended sidings on its tracks up to 10,000 feet, enabling longer trains to pass each other.

 

KCSM’s fleet of locomotives and rolling stock consisted of the following at December 31:

 

 

Under its Concession from the Mexican government, KCSM has the right to operate the rail lines, but does not own the land, roadway or associated structures. The Concession requires KCSM to make investments and undertake capital projects, including capital projects described in a business plan filed every five years with the Mexican government. KCSM may defer capital expenditures with respect to its five-year business plan with the permission of the SCT. However, should the SCT not grant this permission, KCSM’s failure to comply with the commitments in its business plan could result in the Mexican government revoking the Concession.

 

The response to Item 102 of Regulation S-K under Item 1, “Business”, of this Form 10-K and Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” is incorporated by reference in partial response to this Item 2.

 

The matters discussed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates — Provision for Environmental Remediation — Provision for Casualty Claims,” and — “Other — Litigation” are incorporated by reference in this Item 3.

 

No matters were submitted to a vote of security holders during the three month period ended December 31, 2006.

 

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 is 427 W. 12^th Street, Kansas City, Missouri 64105.

 

Michael R. Haverty — Chairman of the Board and Chief Executive Officer — 62 — The information in the Definitive Proxy Statement under the heading “The Board of Directors — Directors Serving Until the Annual Meeting of Stockholders in 2009” with respect to Mr. Haverty is incorporated by reference.

 

Arthur L. Shoener — KCS President and Chief Operating Officer — 60 — The information in the Definitive Proxy Statement in the description of “The Board of Directors — Directors Serving Until the Annual Meeting of Stockholders in 2008” with respect to Mr. Shoener is incorporated by reference.

 

Daniel W. Avramovich — Executive Vice President, Sales & Marketing — 55 — Joined KCS in May 2006 as Executive Vice President, Sales & Marketing. Prior to this, Mr. Avramovich served as President, Network Services — Americas for Exel plc from 2003 to 2006. From 2000 to 2003, he served as President, Exel Direct for Exel plc.

 

Patrick J. Ottensmeyer — Executive Vice President and Chief Financial Officer — 49 — Joined KCS in May 2006 as Executive Vice President and Chief Financial Officer. Prior to joining KCS, Mr. Ottensmeyer served as Financial Advisor/Chief Financial Officer from 2001 to May 2006 for Intranasal Therapeutics, Inc. From 2000 to 2001, he served as Corporate Vice President Finance and Treasurer for Dade-Behring Holdings, Inc. From 1993 to 1999, Mr. Ottensmeyer served as Vice President Finance and Treasurer at BNSF Railway.

 

Warren K. Erdman — Senior Vice President — Corporate Affairs — 48 — Served in this capacity since January 2006. Mr. Erdman served as Vice President - Corporate Affairs of KCS from April 1997 to December 2005, and as Vice President — Corporate Affairs of KCSR from May 1997 to December 2005. Prior to joining KCS, Mr. Erdman was Chief of Staff to United States Senator Kit Bond of Missouri from 1987 to 1997.

 

Jerry W. Heavin — Senior Vice President — International Engineering of KCSR — 55 — Served in this capacity since January 2005, and a director of KCSR since July 2002. Mr. Heavin served as Senior Vice President of Operations from July 2002 to December 2004. Mr. Heavin joined KCSR in September 2001 and served as Vice President of Engineering of KCSR until July 2002. Prior to joining KCSR, Mr. Heavin served as an independent engineering consultant from 1997 through August 2001.

 

Larry M. Lawrence — Senior Vice President and Assistant to Chairman — Strategies and Staff Studies — 44 — Served in this capacity since January 2006. Mr. Lawrence served as Assistant to CEO — Staff Studies and Planning of KCS from November 2001 until December 2005. Prior to joining KCS in 2001, Mr. Lawrence was a strategy consultant for 15 years with McKinsey, A. T. Kearney and KPMG.

 

Paul J. Weyandt — Senior Vice President — Finance and Treasurer — 53 — Served in this capacity since April 2005. He served as Vice President and Treasurer of KCS and of KCSR from September 2001 until March 2005. Before joining KCS, Mr. Weyandt was a consultant to the Structured Finance Group of

GE Capital Corporation from May 2001 to September 2001. Prior to consulting, Mr. Weyandt spent 23 years with BNSF Railway, most recently as Assistant Vice President Finance and Assistant Treasurer.

 

William J. Wochner — Senior Vice President and Chief Legal Officer — 59 — Served in this capacity since February 2007. 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.

 

Richard M. Zuza — Senior Vice President — International Purchasing and Materials — 53 — Joined KCS in November 2005 as the Senior Vice President — International Purchasing and Materials. Prior to joining KCS, Mr. Zuza was Vice President of Procurement for Allstate Insurance Company from 1998 to 2005, Vice President of Purchasing for Gibson Greetings, Inc. for seven years and held a variety of purchasing positions with General Electric Company for 15 years.

 

Michael K. Borrows — Vice President — Financial Reporting and Tax — 39 — Joined KCS in June 2006 as Vice President — Financial Reporting and Tax. Prior to joining KCS, Mr. Borrows spent 11 years at BNSF Railway serving in a variety of financial roles, most recently as General Director Finance. Mr. Borrows is the Company’s Chief Accounting Officer.

 

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, by family.

 

Market Information.

 

The Company’s Common Stock is traded on the New York Stock Exchange. The information set forth in response to Item 201 of Regulation S-K in Note 8 and Note 13 to the Consolidated Financial Statements in Item 8 of this Form 10-K is incorporated by reference in partial response to this Item 5.

 

Dividend Policy.

 

Common Stock.  KCS has not declared any cash dividends on its common stock during the last five fiscal years and it does not anticipate making any cash dividend payments to common stockholders in the foreseeable future. Pursuant to KCSR’s credit agreement, KCS is prohibited from the payment of cash dividends on its common stock.

 

Preferred Stock.  Kansas City Southern is restricted from paying dividends on its Series C Preferred Stock and Series D Preferred Stock when its coverage ratio (as defined in the indentures for KCSR’s 71/2% Senior Notes and 91/2% Senior Notes) is less than 2.0:1. It is the Company’s intention to pay timely dividends on all Preferred Stock in either cash or stock, depending upon the terms of the preferred stock, when dividend payments are not restricted under the covenants of our various debt agreements and the Company has adequate levels of liquidity. In the event that dividends on the Series C Preferred Stock or Series D Preferred Stock are in arrears for six consecutive quarters (or an equivalent number of days in the aggregate, whether or not consecutive), holders of the Series C Preferred Stock or the Series D Preferred Stock, as applicable, will be entitled to elect two of the authorized number of directors at the next annual stockholders’ meeting, and at each subsequent stockholders’ meeting until such time as all accumulated dividends are paid on the Series C Preferred Stock or the Series D Preferred Stock, as applicable, or set aside for payment.

 

See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Recent Developments” for a discussion of recent amendments to the indentures for KCSR’s 71/2% Senior Notes and 91/2% Senior Notes related to these dividend payments.

 

Holders.

 

There were 4,941 record holders of KCS common stock on February 15, 2007.

 

Securities Authorized for Issuance Under Equity Compensation Plans

 

See Part III, Item 12, “Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters” for information about securities authorized for Issuance under KCS’ equity compensation plans.

Performance Graph.

 

The following graph shows the changes in value over the five years ending December 31, 2006, of an assumed investment of $100 in: (i) KCS’ common stock; (ii) the stocks that comprise the Dow Jones Transportation Average Index¹; and (iii) the stocks that comprise the S&P 500 Index². 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 cash dividends are reinvested.

 

COMPARISON OF FIVE YEAR CUMULATIVE TOTAL RETURN

Among Kansas City Southern, the S & P 500 Index

and the Dow Jones Transportation Index

 

 

 

 

¹ The Dow Jones Transportation Average is an index prepared by Dow Jones & Co., Inc., an independent company.

² The S&P 500 is an index prepared by Standard and Poor’s Corporation, an independent company. The S&P 500 Index reflects the change in 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.

 

The selected financial data below (in millions, except per share amounts) should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included under Item 7 of this Form 10-K as well as the consolidated financial statements and the related notes and the Reports of Independent Registered Public Accounting Firms.

 

 

 

 

The response to Item 301 of Regulation S-K under Part II Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K is incorporated by reference in partial response to this Item 6.

 

NON-GAAP FINANCIAL INFORMATION

 

The following tables present full year 2006 non-GAAP financial information previously disclosed by the Company on its website in conjunction with earnings releases, presentations and 8-K filings. The non-GAAP information presented, which management believes is useful, should be considered in addition to, but not as a substitute or preferable to, other information prepared and presented in accordance with GAAP. However, the information is included herein as reference because Management may use this information for comparability purposes when discussing the performance of the Company’s business and believes that the non-GAAP information provided is meaningful and can be particularly useful in assessing comparability of the Company’s performance for the years ended December 31, 2005 and 2006.

 

Summary Income Statement Information

 

Calculation of 2005 non-GAAP year to date earnings includes: (i) KCSM’s first quarter 2005 amounts prior to its consolidation on April 1, 2005 and (ii) excludes charges related to the acquisition and the write-off

of deferred profit sharing in the second quarter of 2005, (iii) excludes the unusually large charge to Casualty and insurance reflecting a comprehensive study as well as the first time adoption of an actuarial approach for projecting expense related to certain casualty claims, and (iv) excludes the one-time non-cash gain as a result of the VAT settlement with the Mexican Government in the third quarter of 2005.

 

 

Calculation of Earnings Before Interest, Income Taxes, Depreciation and Amortization and Non-cash Equity Earnings from Unconsolidated Subsidiaries (a)

 

Calculation of interest expense to include first quarter KCSM interest

 

 

 

Reconciliation of Free Cash Flow to Net Cash Provided by Operating Activities

 

 

The following discussion is intended to clarify and focus on 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 these consolidated financial statements, the related notes and the Reports of Independent Registered Public Accounting Firm thereon, and other information included in this report.

 

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Cautionary Information” for cautionary statements concerning forward-looking comments.

 

CORPORATE OVERVIEW

 

Kansas City Southern, a Delaware corporation, is a holding company with principal operations in rail transportation and its principal subsidiaries and affiliates including the following:

 

 

 

KCS, as the holding company, supplies its various subsidiaries with managerial, legal, tax, financial and accounting services, in addition to managing other “non-operating” investments.

 

EXECUTIVE SUMMARY

 

2006 Financial Overview.

 

The Company achieved consolidated net income of $108.9 million in 2006, as compared to net income of $100.9 million in 2005. The 2005 net income includes a non-recurring gain of $131.9 million related to the VAT/Put settlement. Excluding this non recurring item, net income increased $139.9 million over the prior year.

 

Operating income increased $242 million in 2006 to $304.3 million as compared to $62.3 million in 2005. The increase in operating income was driven primarily by increased revenues during the year. The Company achieved record revenues of $1,659.7 million in 2006, which was a 23% increase over revenues of $1,352 million in 2005. Revenue in 2006 included a full year of consolidated results. The revenue increase was primarily driven by price increases, new and expanding business in both the U.S. and Mexico, and by the continued integration of KCSM operations in the consolidated results. Revenue growth in 2006 was 9% over 2005, including pro forma KCSM revenue for the full year in 2005.

 

Cash flows from operations increased to $267.5 million in 2006 compared with $178.8 million in 2005, an increase of $88.7 million. Capital expenditures are a significant use of cash flows annually due to the capital intensive nature of railroad operations. Cash used for capital expenditures in 2006 was $241.8 million as compared to $275.7 million in 2005.

 

2007 Outlook.

 

Kansas City Southern expects to continue to integrate U.S. and Mexico operations and management with a focus on execution and realizing the full value of the network KCS has built. Consolidated revenue growth in 2007 is expected to be in line with 2005 — 2006 (including KCSM’s 2005 proforma results). Price increases and higher volume are expected to be key drivers of growth while KCS continues to position its network to increase length of haul and cross border traffic, where carload growth is expected to outpace economic growth and intermodal growth is expected to increase substantially.

 

With continued productivity increases in operations as well as the projected revenue growth, the full year operating ratio for 2007 is expected to fall below 80%; although, the Company believes seasonality of business will have an impact on the current quarter-over-quarter improvement trends in the first half of the year.

 

The Company believes that liquidity will continue to improve as will the Company’s key credit statistics with anticipated improvements in operating income, continued focus on working capital reduction and other balance sheet opportunities.

 

The Company projects cash capital expenditures to maintain the railroad and meet anticipated future demand will be approximately $270 million in 2007. KCS also plans to acquire 150 new locomotives through operating lease arrangements at a cost of about $300 million. It is currently projected that U.S. operations will take delivery of 60 locomotives and 90 locomotives will be used in Mexico.

 

Panama Canal Railway, an equity investment of KCS, is also expected to continue strong growth in volumes and cash flow.

 

RECENT DEVELOPMENTS

 

Preferred Stock Dividends.  On January 12, 2007, the Company declared a cash dividend on the 4.25% Redeemable Cumulative Convertible Perpetual Preferred stock, series C (“Series C Preferred Stock”) and a stock dividend on the 5.125% Cumulative Convertible Perpetual Preferred Stock, Series D (“Series D Preferred Stock”) for dividends in arrears that were due May 15, 2006, August 15, 2006 and November 15, 2006, and the dividend payment due February 15, 2007. The dividend was paid February 15, 2007, to stockholders of record on February 5, 2007. The Company also declared a cash dividend on the 4%, noncumulative Preferred Stock, payable April 3, 2007, to stockholders of record on March 12, 2007.

 

Consent Solicitation.  On January 29, 2007, KCSR commenced a consent solicitation to amend the indentures under which KCSR’s 91/2% Senior Notes due 2008 (“91/2% Notes”) and 71/2% Senior Notes due 2009 (“71/2% Notes” and together with the 91/2% Notes, the “Notes”) were issued. The purpose of the consent solicitation was to (i) resolve an inconsistency in the inclusion of certain expenses, but not the income, of restricted subsidiaries in the calculation of the consolidated coverage ratio under the indentures, (ii) amend the definition of refinancing indebtedness to allow the inclusion of certain related premiums, interest, fees and expenses in permitted refinancing indebtedness and (iii) obtain waivers of any defaults arising from certain actions taken in the absence of such proposed amendments. On February 5, 2007, KCSR obtained the requisite consents from the holders of each series of Notes to amend their respective indentures as described above and executed supplemental indentures containing such amendments and waivers.

 

Credit Facility Waiver.  On January 31, 2007, KCS provided written notice to the lenders under the 2006 Credit Agreement of certain representation and other defaults under the 2006 Credit Agreement arising from the potential defaults which existed under the KCSR indentures as described above. These defaults limited KCSR’s access to the revolving credit facility. In its notice of default, the Company also requested that the lenders waive these defaults. On February 5, 2007 the Company received a waiver of such defaults from all of the lenders under the 2006 Credit Agreement. The Company is currently not in default of the 2006 Credit Agreement and has access to the revolving credit facility.

 

Claims Asserted under the TMM Acquisition Agreement.  As part of the acquisition of Grupo KCSM in 2005, KCS issued escrow notes to TMM totaling $47.0 million which are subject to reduction for certain potential losses related to incorrect representations and warranties or breaches of covenants in the Acquisition Agreement by TMM. On January 29, 2007, KCS advised TMM that KCS intended to assert claims for indemnification under the Acquisition Agreement related to representations and warranties made by TMM. On February 1, 2007, KCS received a notice from TMM indicating that TMM would seek damages from KCS under the Acquisition Agreement, aggregating approximately $43 million as well as other unspecified damages. The parties are obligated under the Acquisition Agreement to attempt to resolve their differences informally and, if not successful, then to submit them to binding arbitration.

 

RESULTS OF OPERATIONS

 

Year Ended December 31, 2006, Compared with the Year Ended December 31, 2005

 

Net Income.  Consolidated net income increased $139.9 million excluding the 2005 non-recurring VAT/Put settlement for the year ended December 31, 2006, compared to the same period in 2005. Including the $131.9 million VAT/Put settlement in 2005, consolidated net income increased $8 million. Operating income increased by $242.0 million primarily driven by targeted price increases and fuel surcharge, new and expanded existing business in both the U.S. and Mexico segments, and the integration of KCSM operations and a full year of consolidated operating results. Operating expenses increased by only 5% due to increased efficiencies from the integration of KCSM.

 

The following summarizes the consolidated income statement components of KCS (in millions).

 

 

U.S. Segment.

 

Revenues.  The following summarizes U.S. revenues (in millions) and carloads statistics (in thousands).  Certain prior period carloads and intermodal units have been reclassified to reflect changes in the business groups and to conform to the current period presentation.

 

 

For the year ended December 31, 2006, revenues increased $81.3 million compared to the prior year. The U.S. segment experienced revenue increases in all commodity groups except for the intermodal and automotive business, which decreased slightly due to a decline in automotive business driven by lower output and short term plant shutdowns in 2006. Overall increases in the majority of the commodities were driven by targeted price improvements, including increased fuel surcharges. The following discussion provides an analysis of revenues by commodity group.

 

Chemical and Petroleum.  Revenues increased for all of the chemical and petroleum products for the year ended December 31, 2006, due to targeted rate increases in the petroleum, agricultural chemicals and industrial gases sectors, and increased traffic volumes. Pricing improvement and stronger economic conditions during 2006 accounted for a majority of the growth in revenue in the year, while growth in the third and fourth quarters also reflected the Gulf Coast refineries’ recovery from the past year’s hurricanes.

 

Forest Products and Metals.  Revenues increased in forest products and metal commodities for the year ended December 31, 2006, primarily due to targeted rate increases. Decreases in volume can be attributed to the lumber and chip products due to rising mortgage rates. This volume decline was only partially offset by increases in volume from higher production in the metals, rolled paper and military products.

 

Agricultural and Mineral.  Revenues increased in all agricultural and mineral products for the year ended December 31, 2006, due to targeted rate adjustments and an increase in velocity over certain corridors and business sectors. Overall improvement in velocity of unit grain and mineral trains accounted for a majority of the revenue growth during 2006. Declining market conditions during the third and fourth quarters of the year accounted for the decline in volume with the primary decrease in export grain.

 

Intermodal and Automotive.  Revenues decreased in the intermodal and automotive business for the year ended December 31, 2006, due to declines in the automotive business from suspended production at an automotive plant for a majority of the year. This decrease was offset partially by increased revenues in the intermodal business which were driven by higher volumes from existing customers as well as the generation of new intermodal business.

 

Coal.  Revenues increased for the year ended December 31, 2006, as a result of higher traffic volumes at certain electric generating stations in order to rebuild inventory stockpiles. The ability to rebuild stockpiles has been made possible by improved efficiencies at the coal mines and increased velocity achieved by KCSR and origin carriers.

 

Operating Expenses.  For the year ended December 31, 2006, U.S. operating expenses increased $0.8 million. The following summarizes the Company’s U.S. operating expenses (in millions).

 

 

Compensation and benefits.  Compensation and benefits expense increased $19.5 million for the year ended December 31, 2006, compared to 2005 as the result of increased incentive compensation, annual salary increases, increase in management headcount, and an increase in stock based compensation. Incentive compensation is tied to the financial results of the Company and accounted for $9.3 million of the increase. Stock based compensation increased by $2.9 million partially as a result of the implementation of SFAS No. 123(R). Additionally, the remaining increase is the result of annual salary increases and certain increases in headcount.

 

Purchased services.  Purchased services expense decreased $1.8 million for the year ended December 31, 2006, compared to the same period in 2005. The decrease was primarily driven by decreases in legal costs, locomotive repair costs and rental income received on locomotives leased to Mexico operations on a short-term basis. The decreases were offset by increases in joint facilities expenses due to higher traffic and an increase in auto and truck repair expense.

 

Fuel.  Fuel expense increased $17.0 million for the year ended December 31, 2006, compared to 2005 primarily as a result of a 7.9% increase in the average price per gallon and a 7.2% increase in consumption.

 

Equipment costs.  Equipment costs increased $13.8 million for the year ended December 31, 2006, compared to 2005 as a result of entering into two new locomotive lease agreements for $14.8 million and new

freight car leases for $4.5 million during the year. This increase was offset by a decrease in car hire expense due to a reduction in the use of non-KCSR freight cars.

 

Depreciation and amortization.  Depreciation and amortization expense increased $5.7 million for the year ended December 31, 2006, compared to 2005, primarily as a result of an increase in assets placed into service during the year. This increase was partially offset by an updated depreciation study which was completed during the year and resulted in a $3.0 million reduction in expense in the 4^th quarter.

 

Casualties and insurance.  Casualties and insurance expense decreased $43.8 million for the year ended December 31, 2006, compared to 2005. During the third quarter of 2005, the Company recorded a $37.8 million pre-tax charge for personal injury liabilities based upon an actuarial study in 2005. The remaining decrease in 2006 was primarily driven by a lower number of incidence as well as a decrease in the severity of derailments during the year compared to the prior year.

 

Other.  Other expense decreased $9.6 million for the year ended December 31, 2006, compared to 2005 primarily due to a $13.9 million reimbursement from the Mexico segment for shared service expenses paid by the U.S. segment during 2006. This was offset by an increase of $6.7 million in materials and supplies primarily as a result of price increases in freight car wheels.

 

Mexico Segment.

 

KCS acquired a controlling interest in Grupo KCSM effective April 1, 2005. The 2005 results reflect charges and costs associated with the acquisition and integration, as well as the effect of valuation adjustments as required by purchase accounting. Since April 1, 2005, the financial results of Grupo KCSM have been consolidated into KCS. Prior to that date, the investment for Grupo KCSM was accounted for under the equity method. Although not consolidated prior to April 1, 2005, revenue and expense information below includes Grupo KCSM results for the 1^st quarter of 2005 for comparative purposes. Accounting policies for Grupo KCSM prior to the acquisition were materially consistent with U.S. operations, however, certain adjustments have been made to the results presented for comparability.

 

Revenues.  Mexico’s revenues (in millions) and carloads statistics (in thousands) follow.

 

 

Revenues for the year ended December 31, 2006 totaled $774.0 million compared to $717.6 million for the comparable year ended December 31, 2005, which represented an increase of $56.4 million. Revenues increased despite a decrease in carloads mainly due to a reduction in the movement in finished vehicles for exportation. The increase in 2006 was mainly attributable to targeted rate increases and fuel surcharge. Carloads are a standard measure used by KCS to determine the volume of traffic transported over its rail lines. Imports into Mexico from the U.S., Canada and overseas represented approximately 56.3% and 56.2% of total revenues in 2006 and 2005, respectively. Approximately 77.8% of total revenues in 2006 were attributable to international freight.

 

Chemical and Petroleum Products.  Revenues rose $19.4 million in 2006 primarily due to price increases, fuel surcharge revenue and volume increases over the prior year. The volume recovery increase was largely attributable to Hurricanes Katrina and Rita which had adversely impacted the Gulf coast refineries. Volume recovery was seen in fuel oil, diesel, gasoline and pet coke during 2006.

 

Forest Products and Metals.  Revenues increased $26.8 million in 2006 compared to 2005, primarily due to price strategies, longer hauls and increased fuel surcharge. Targeted rate increases were implemented in 2006 for movements of steel slabs and steel coil imports. Increased revenue was seen from longer hauls to Laredo as a result of a customer’s relocation of its distribution center from Zacatecas to Tuxtepec. Increases in the number of cross border paper imports were seen during the year as well.

 

Agriculture and Mineral.  Revenues from agricultural products increased $13.5 million compared to 2005 primarily as a result of targeted rate increases and fuel surcharges. Volume increases in corn and sugar were partially offset by reductions in import shipments of soybeans, sorghum and wheat products. Revenues also grew due to an embargo on Ferromex lines. There was also increased activity during the last quarter of 2006 not expected to be imported through the U.S.-Mexico border. The fructose market increased and it is still growing without quotas on imports. The revenue increase has been favorable with movements of grain and products from U.S. origin to destinations on the KCSM lines. These increases were negatively affected by a reduction of volumes of sand and clay products, and lower traffic in route from Jaltipan to Queretaro, due to dwell times at Ferrovalle. Additionally revenues were also affected by the reduction in consumption of limestone in Lázaro Cárdenas during the second quarter 2006.

 

Intermodal and Automotive.  Intermodal revenue increased $7.8 million during 2006 compared to 2005, as a result of increased numbers of steamship carriers that call at the port of Lázaro Cárdenas and consistent transit times on Intermodal trains. Automotive revenue decreased $18.4 million in 2006 compared to 2005, as a result of a reduction in the movement of finished vehicles for exportation to the U.S. and Canadian markets. Additionally, the movements of importation of finished vehicles, as well as the domestic distribution of these vehicles, have declined due to the logistics of their transportation.

 

Operating Expenses.  The following summarizes Mexico operating expenses (in millions):

 

 

Compensation and benefits.  For the year ended December 31, 2006, salaries, wages and employee benefits decreased $1.0 million compared to 2005. The decrease reflects a reduction in headcount and the depreciation effect of the Mexican peso against the U.S. dollar during 2006. This decrease was partially offset by the annual salaries increase and the increase in wages and fringe benefits resulting from labor negotiations in July 2006.

 

Purchased services.  Purchased services decreased $14.5 million in 2006 compared to 2005. Certain trackage rights that were not used during 2006 resulting in lower costs, amortization of deferred credits established in connection with the push down of purchase accounting, and additional capitalization of certain overhead costs, reduced purchased services during the year. These decreases were slightly offset by increases in management and professional fees during 2006.

 

Fuel.  Fuel expenses increased $6.5 million in 2006 compared to 2005 primarily due to the volatility of fuel prices during 2006. KCSM’s average price per gallon for fuel increased 4.6% in 2006 as compared to the prior year.

 

Equipment cost.  Equipment cost decreased $5.5 million compared to 2005. This decrease was attributed mainly to a reduction in the use of non-KCSM freight cars as a result of velocity and operations improvement. This decrease was partially offset by the amortization of certain deferred charges and credits established in connection with the push down of purchase accounting related to the fair value of operating leases for freight cars.

 

Casualties and insurance.  During 2006, casualties and insurance decreased $8.5 million compared to 2005. This decrease was primarily the result of lower costs associated with derailments compared to activity that occurred during the second and third quarter of 2005.

 

Employees’ statutory profit sharing.  The $35.7 million decrease in employee statutory profit sharing expense for the year ended December 31, 2006 compared to 2005 was a result of four Supreme Court decisions in May of last year which denied the deductibility of NOL’s in a company’s profit sharing liability calculation. As a result of these court rulings the deferred profit sharing asset associated with these NOL’s was written down during 2005, which resulted in a non-cash charge to income of $35.6 million.

 

Other.  Other expenses decreased $19.9 million compared to December 31, 2005. This decrease primarily reflects lower bad debt expense as compared to 2005 of approximately $9.3 million, the recognition of transition cost of $2.0 million in 2005, a charge due to the revaluation of the inventory parts associated with the maintenance of the catenary line in the second quarter 2005 of $1.6 million and losses on sale of property prior to adoption of the group method of depreciation on April 1, 2005, partially offset by a $1.3 million increase in other leases.

 

Consolidated Non-Operating Expenses.

 

Consolidated Interest Expense.  Consolidated interest expense increased $33.7 million for the year ended December 31, 2006, driven primarily by the additional three months of KCSM interest expense. KCSM’s interest expense for the three months ended March 31, 2005, was $27.4 million. The remaining difference was due to higher average balances of and increased interest rates on floating rate debt in the current year.

 

Consolidated Debt Retirement Costs.  Consolidated debt retirement costs increased $0.4 million for the year ended December 31, 2006, compared to the year ended December 31, 2005. During the year ended December 31, 2006, KCSR entered into an amended and restated credit agreement and wrote off $2.2 million and KCSM refinanced its 10.25% senior notes and wrote off $2.6 million in unamortized debt issuance costs. For the year ended December 31, 2005, $4.4 million in unamortized debt issuance costs were written off in connection with the refinancing of KCSM’s 11.75% debentures and its first amended and restated credit agreement.

 

Foreign Exchange.  For the year ended December 31, 2006, the foreign exchange loss of $3.7 million compared to a gain of $3.5 million for the same period in 2005. During the year 2006 the U.S. dollar appreciated approximately 1.7% relative to the Mexican peso.

 

Equity in Net Earnings (Losses) of Unconsolidated Affiliates.  Equity in earnings from unconsolidated affiliates was $7.3 million for the year ended December 31, 2006, compared to $2.9 million for the year ended December 31, 2005. Significant components of this change follow:

 

 

 

Other Income.  Other income increased $5.4 million for the year ended December 31, 2006, due to the sale of land and other long term assets that were not associated with KCS’s railroad operations during 2006.

 

Consolidated Income Tax Provision (Benefit).  For the year ended December 31, 2006, KCS’ income tax expense was $45.4 million, a change of $52.5 million as compared to a $7.1 million benefit for the year ended December 31, 2005. The effective tax rate increased from (9.3%) to 29.4% for the years ended December 31, 2005 and 2006, respectively. This increase was primarily attributable to the absence of one-time items such as the non-taxable VAT/Put settlement which occurred in 2005 and the 2005 write-off of deferred profit sharing in Mexico.

 

Following the acquisition of control of Grupo KCSM in 2005, the Company has not provided U.S. federal income taxes on the undistributed earnings of Grupo KCSM since the Company intends to reinvest such earnings indefinitely outside of the United States.

 

Year Ended December 31, 2005, Compared with the Year Ended December 31, 2004

 

Net Income.  Consolidated net income for 2005 increased $76.5 million compared to 2004 primarily as a result of a $131.9 million gain resulting from the VAT/Put Settlement, partially offset by a reduction in operating income of $21.2 million. Additionally, consolidated net income increased due to a reduction in provision for income taxes of $30.7 million.

 

The reduction in consolidated operating income was driven primarily by an additional $37.8 million charge in 2005 to recognize additional costs related to occupational and personal injury claims determined as a result of the annual actuarial study, which was completed during the third quarter of 2005, and the write off of KCSM’s deferred tax asset related to statutory profit sharing. On a consolidated basis, both revenues and operating expenses were significantly impacted by the acquisitions completed during the year. In addition to the acquisitions, revenue growth for 2005 continued to be driven by increased volume, targeted rate increases and increased fuel surcharges to help offset rising fuel prices. Consolidated operating costs generally increased consistent with the volume increases, although price increases also impacted compensation and benefits and fuel expense.

 

The following table summarizes the consolidated income statement components of KCS (in millions).  Certain prior period amounts have been reclassified to reflect changes to the current period presentation.

 

U.S. Segment.

 

Revenues.  The following table summarizes U.S. revenues, including the revenues and separate carload statistics of KCSR, and Mexrail, for the year ended December 31, 2005 (in millions). For the year ended December 31, 2004, the revenue and carload statistics are KCSR only. Certain prior period amounts have been reclassified to conform to the current period presentation.

 

 

For the year ended December 31, 2005, U.S. revenues increased $164.9 million. The Mexrail acquisition accounted for $73.3 million of the increase in revenues for the year ended December 31, 2005. U.S. revenue also experienced increases in all commodity groups due to a combination of higher carloadings, targeted price improvements and increased fuel surcharge revenue. Fuel surcharges increased to $52.0 million, which accounted for $35.3 million of the increase in revenues for the year ended December 31, 2005, compared to the same period in 2004. The following discussion provides an analysis of the segment’s revenues by commodity group. Pending completion of the ongoing effort to change the Tex-Mex mark and finalize its merger into KCS operations, carload data are presented based on the combination of the carloads for KCSR and Mexrail, without elimination for cars interchanged between the two roads.

 

Chemical and Petroleum.  For the year ended December 31, 2005, U.S. chemical and petroleum products experienced increases in revenues in all commodity groups with the exception of inorganic chemicals. These increases were attributed to higher production, certain targeted rate increases and fuel surcharges. These revenue increases were partially offset by the effects of plant and production shutdowns resulting from the hurricanes during the second half of 2005. The impact of the Mexrail consolidation increased revenues $12.1 million in the chemical and petroleum product commodities for the year ended December 31, 2005.

 

Forest Products and Metals.  For the year ended December 31, 2005, forest products and metals revenue for the U.S. segment experienced growth in all commodities compared to the same period in 2004. For the year to date period, these increases resulted primarily from certain targeted rate increases and fuel surcharges partially offset by the impact of hurricanes in the 3rd quarter of 2005. For the year ended December 31, 2005, the consolidation of Mexrail contributed $19.0 million to forest products and metals revenue.

 

Agricultural and Mineral.  U.S. revenues in the agricultural and mineral products business unit increased for the year ended December 31, 2005. The increases were primarily the result of targeted rate increases and fuel surcharges. Additionally, for the year ended December 31, 2005, all commodities, except grain, experienced increased traffic due to increased production. U.S. segment domestic grain carloads decreased, primarily due to a slowdown in equipment cycle times resulting in lower equipment availability for the year while the impact of local harvests moving to local feed mills reduced traffic in the third quarter of 2005 compared to the same period in 2004. Export grain carloads decreased primarily as a result of a decrease in gulf coast export traffic including the effects of hurricane weather in the gulf coast region. For the year ended

December 31, 2005, the consolidation of Mexrail contributed $30.7 million to agricultural and mineral products revenue.

 

Intermodal and Automotive.  Revenue for the U.S. segment intermodal and automotive commodity group for the year ended December 31, 2005, increased $9.8 million compared to the same period in 2004. Excluding the impact of the acquisition of Mexrail, intermodal traffic declined for the year ended December 31, 2005. The declines were the result of changes in shipper traffic patterns as well as the effects of hurricane weather during the third quarter of 2005. Automotive traffic decreased as a result of decreased volumes from manufacturers for the year ended December 31, 2005. For the year ended December 31, 2005, the consolidation of Mexrail contributed $5.5 million to intermodal and automotive products revenue.

 

Coal.  Increases in U.S. segment coal revenues for the year ended December 31, 2005, compared to the same period in 2004 were due primarily to the addition of two new coal customers that were previously served by other railroads, certain targeted rate increases related to renegotiated contracts and overall increases in carloadings and traffic volumes at certain electric generating stations in response to demand. Mexrail has no significant coal revenues.

 

Operating Expenses.  For the year ended December 31, 2005, U.S. operating expenses increased $203.3 million (36.6%), when compared to the same period in 2004. Of this increase, $83.3 million was attributable to the consolidation of Mexrail’s operations for the year ended December 31, 2005. The following table summarizes U.S. operating expenses of KCSR and Mexrail for the year ended December 31, 2005 (in millions).  For the year ended December 31, 2004, the operating expenses are KCSR only.

 

 

Compensation and benefits.  Increases in compensation and benefits expense for the year ended December 31, 2005, compared to the same period in 2004 were primarily the result of annual wage and salary rate increases which were effective July 1, 2004, as well as higher employee counts. For the year ended December 31, 2005, the consolidation of Mexrail added $19.4 million to compensation and benefits expense. The average headcount for the year ended December 31, 2005, was approximately 3,060 compared to approximately 2,740 for the same period in 2004, including an increase of employees as a result of the consolidation of Mexrail.