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

 
| **FORM 10-Q** |
|---------------|
|          |   |
| (X)           | QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES |
|          | EXCHANGE ACT OF 1934 |
|          | For the quarterly period ended **JUNE 30, 2003** |
|          |   |
| ( )      | TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES |
|          | EXCHANGE ACT OF 1934 |
|          | For the transition period from __________ to  __________ |
|          | Commission  file numbers 1-743; 1-3744; 1-4793; 1-546-2 |

** **

** **

 

 

 

 
| **NORFOLK SOUTHERN RAILWAY COMPANY**                        |
|-------------------------------------------------------------|
| (Exact  name of registrant as specified in its charter)**** |

** **
| Virginia                                                  | **53-6002016**                     |
|-----------------------------------------------------------|------------------------------------|
| (State  or other jurisdiction of                          | (IRS  Employer Identification No.) |
| incorporation  or organization)                           |                               |
|                                                      |                               |
|                                                      |                               |
| **Three Commercial Place**                                |                               |
| Norfolk, Virginia                                         | **23510-2191**                     |
| (Address  of principal executive offices)                 | Zip  Code                          |
|                                                      |                               |
| Registrant's  telephone number, including area code       | **(757) 629-2680**                 |
|                                                      |  ****                         |
| No  Change                                                |
| (Former  name, former address and former fiscal year,**** |
| if  changed since last report.)****                       |

 
| Indicate by check mark whether the registrant  (1) has filed all reports required to be filed by Section 13   |
|--------------------------------------------------------------------------------------------------------------------|
| or 15(d) of the Securities Exchange Act of  1934 during the preceding 12 months (or for such shorter               |
| period that the registrant was required to  file such reports), and (2) has been subject to such filing       |
| requirements for the past 90 days.                                                                       | (X) Yes    | (  ) No |
|                                                                                                               |   |   |
| Indicate by check mark whether registrant is  an accelerated filer (as defined in Rule 12b-2 of The Exchange Act). |
|                                                                                                               | (  ) Yes    | (X) No |
|                                                                                                               |   |   |
| The number of shares outstanding of each of  the registrant's classes of Common Stock, as of the last              |
| practicable date:                                                                                                  |
|                                                                                                               |   |
| Class                                                                                                              | Outstanding as of June 30, 2003 |
| Common  Stock (par value $1.00)                                                                                    |                 16,668,997 |
|                                                                                                               |   |
|                                                                                                                    |  |  |  |

TABLEOF CONTENTS

 
|           |                    |                                               | Page   |
|----------------|-------------------------|----------------------------------------------------|--------|
|           |                    |                                               |   |
| Part I.        | Financial  information: |
|           |                    |                                               |   |
|           | Item  1.                | Financial  statements:                             |   |
|           |                    |                                               |   |
|           |                    | Consolidated  Statements of Income                 | 3      |
|           |                    | Three  and Six Months Ended June 30, 2003 and 2002 |
|           |                    |                                               |   |
|           |                    | Consolidated  Balance Sheets                       | 4      |
|           |                    | June  30, 2003 and Dec. 31, 2002                   |   |
|           |                    |                                               |   |
|           |                    | Consolidated  Statements of Cash Flows             | 5      |
|           |                    | Six  Months Ended June 30, 2003 and 2002           |
|           |                    |                                               |   |
|           |                    | Notes  to Consolidated Financial Statements        | 6      |
|           |                    |                                               |   |
|           |                    | Independent  Accountants' Review Report            | 12     |
|           |                    |                                               |   |
|           | Item  2.                | Management's  Discussion and Analysis of           | 13     |
|           |                    | Financial  Condition and Results of Operations     |
|           |                    |                                               |   |
|           | Item  3.                | Quantitative  and Qualitative Disclosures          | 19     |
|           |                    | About  Market Risks                                |   |
|           |                    |                                               |   |
|           | Item  4.                | Controls  and Procedures                           | 19     |
|           |                    |                                               |   |
| Part II.       | Other  Information:     |                                               |
|           |                    |                                               |   |
|           | Item  6.                | Exhibits  and Reports on Form 8-K                  | 20     |
|           |                    |                                               |   |
| Signatures     |                    | 21                                                 |
|           |                    |                                               |   |
| Exhibit  Index |                    | 22                                                 |
|                |                         |                                                    |        |  |  |

 

2**PART I. FINANCIAL INFORMATION**

** **

**Item 1. Financial Statements.**

 

** **

**NORFOLK SOUTHERN RAILWAY COMPANY ANDSUBSIDIARIES**

**(A Majority-Owned Subsidiary of Norfolk SouthernCorporation [NS])**

**Consolidated Statements of Income**

**($ in millions)**

**(Unaudited)**

 

                                                                                                                   
|                                                                                        | **Three months  Ended** | **Six Months  Ended** |
|---------------------------------------------------------------------------------------------|-------------------------|-----------------------|
|                                                                                        | **June 30,**            | **June 30,**          |
|                                                                                        | **2003**                | **2002**              | **2003** | **2002** |
|                                                                                        |                    |                  |   |   |   |   |   |   |
| ***Railway  operating revenues:***                                                          |                    |                  |   |   |   |   |   |   |
|    Coal                                                                      | $                       | 389              | $ | 350  | $ | 743  | $ | 709  |
|    General  merchandise                                                      |                    | 944              |   | 948  |   | 1,862  |   | 1,817  |
|    Intermodal                                                                |                    | 256              |   | 249  |   | 503  |   | 478  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
|       Total  Railway Operating Revenues                       |                    | 1,589            |   | 1,547  |   | 3,108  |   | 3,004  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
| ***Railway  operating expenses:***                                                          |                    |                  |   |   |   |   |   |   |
|    Compensation  and benefits                                                |                    | 401              |   | 377  |   | 801  |   | 760  |
|    Materials,  services and rents                                            |                    | 487              |   | 454  |   | 946  |   |  907  |
|    Conrail  rents and services (Note 2)                                      |                    | 118              |   | 115  |   | 237  |   |  236  |
|    Depreciation                                                              |                    | 123              |   | 125  |   | 246  |   | 248  |
|    Diesel  fuel                                                              |                    | 93               |   | 84  |   | 197  |   | 165  |
|    Casualties  and other claims                                              |                    | 48               |   | 37  |   | 99  |   | 72  |
|    Other                                                                     |                    | 73               |   | 78  |   | 147  |   | 139  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
|       Total  Railway Operating Expenses                       |                    | 1,343            |   | 1,270  |   | 2,673  |   | 2,527  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
|          Income  from railway operations       |                    | 246              |   | 277  |   | 435  |   | 477  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
| Other  income (expense) - net                                                          |                    | (65)                  |   | (60) |   | (116) |   | (112) |
| Interest  expense on debt                                                                   |                    | (5)                   |   | (7) |   | (12) |   | (16) |
|                                                                                        |                    |                  |   |   |   |   |   |   |
|          Income  before income taxes and       |                    |                  |   |   |   |   |   |   |
|             accounting  changes |                    | 176              |   | 210  |   | 307  |   | 349  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
| Provision  for income taxes                                                                 |                    | 68               |   | 84  |   | 119  |   | 138  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
|          Income  before accounting changes     |                    | 108              |   | 126  |   | 188  |   | 211  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
| Cumulative  effect of changes in accounting                                                 |                    |                  |   |   |   |   |   |   |
|    principles,  net of taxes (Note 1)                                        |                    | --               |   | --  |   | 104  |   | --   |
|                                                                                        |                    |                  |   |   |   |   |   |   |
|       Net  Income                                             | $                       | 108              | $ | 126  | $ | 292  | $ | 211  |
|                                                                                        |                    |                  |   |   |   |   |   |   |
|                                                                                        |                    |                  |   |   |   |   |   |   |
| *See  accompanying notes to consolidated financial statements.*                             |

 

3

**NORFOLK SOUTHERN RAILWAY COMPANY ANDSUBSIDIARIES**

**(A Majority-Owned Subsidiary of Norfolk SouthernCorporation [NS])**

**Consolidated Balance Sheets**

**($ in millions)**

**(Unaudited)**

** **

 

|                                                                            | **June 30,** | **Dec. 31,** |
|---------------------------------------------------------------------------------|--------------|--------------|
|                                                                            | **2003**     | **2002**     |
| ***Assets***                                                                    |         |         |   |   |
| Current assets:                                                                 |         |         |   |   |
|    Cash and cash equivalents                                     | $            | 76           | $ | 130  |
|    Accounts receivable, net  (Note 2)                            |         | 138          |   | 117  |
|    Due from Conrail (Note 2)                                     |         | 6            |   | 6  |
|    Materials and supplies                                        |         | 101          |   | 95  |
|    Deferred income taxes                                         |         | 188          |   | 174  |
|    Other current assets                                          |         | 82           |   | 131  |
|       Total  current assets                       |         | 591          |   | 653  |
|                                                                            |         |         |   |   |
| Investments (Note 4)                                                            |         | 754          |   | 703  |
| Properties less accumulated depreciation                                        |         | 11,162       |   | 10,837  |
| Other assets                                                                    |         | 680          |   | 660  |
| **      **Total  assets                           | $            | 13,187       | $ | 12,853  |
|                                                                            |         |         |   |   |
| ***Liabilities and Stockholders' Equity***                                      |         |         |   |   |
| Current liabilities:                                                            |         |         |   |   |
|    Accounts payable                                              | $            | 871          | $ | 860  |
|    Income and other taxes                                        |         | 176          |   | 187  |
|    Due to NS - net (Note 2)                                      |         | 389          |   | 384  |
|    Due to Conrail (Note 2)                                       |         |  78     |   | 86  |
|    Other current liabilities                                     |         |  123    |   | 122  |
|    Current maturities of  long-term debt                         |         |  102    |   | 94  |
|       Total  current liabilities                  |         |  1,739  |   | 1,733  |
|                                                                            |         |         |   |   |
| Long-term debt                                                                  |         |  856    |   | 763  |
| Other liabilities                                                               |         |  969    |   | 971  |
| Due to Conrail (Note 2)                                                         |         |  618    |   | 513  |
| Minority interests                                                              |         |  8      |   | 3  |
| Deferred income taxes                                                           |         |  4,217  |   | 4,057  |
|       Total  liabilities                          |         |  8,407  |   | 8,040  |
|                                                                            |         |         |   |   |
| Stockholders' equity:                                                           |         |         |   |   |
|    Serial preferred stock                                        |         | 55           |   | 55  |
|    Common stock                                                  |         | 167          |   | 167  |
|    Additional paid-in capital                                    |         |  709    |   | 709  |
|    Accumulated other  comprehensive income (Note 4)              |         | 259          |   | 266  |
|    Retained income                                               |         | 3,590        |   | 3,616  |
|       Total  stockholders' equity                 |         | 4,780        |   | 4,813  |
|                                                                            |         |         |   |   |
|       Total  liabilities and stockholders' equity | $            | 13,187       | $ | 12,853  |
|                                                                            |         |         |   |   |
| *See accompanying notes to consolidated  financial statements.*                 |

** **

4****

** **

**NORFOLK SOUTHERN RAILWAY COMPANY ANDSUBSIDIARIES**

**(A Majority-Owned Subsidiary of Norfolk SouthernCorporation [NS])**

**Consolidated Statements of Cash Flows**

**($ in millions)**

**(Unaudited)**

** **

 

|                                                                                                                                 | Six Months  Ended |
|--------------------------------------------------------------------------------------------------------------------------------------|-------------------|
|                                                                                                                                 | **June  30,**     |
|                                                                                                                                 | **2003**          | **2002** |
| ***Cash  flows from operating activities***                                                                                          |              |   |   |   |
|    Net  income                                                                                                        | $                 | 292   | $ | 211  |
|    Reconciliation  of net income to net cash                                                                          |              |   |   |   |
|       provided  by operating activities:                                                               |              |   |   |   |
|          Net  cumulative effect of changes in accounting principles                     |              | (104) |   | --  |
|          Depreciation                                                                   |              |  248  |   | 248  |
|          Deferred  income taxes                                                         |              | 61  |   | 74  |
|          Gains  and losses on properties and investments                                |              | (5) |   | (12) |
|          Changes  in assets and liabilities affecting operations:                       |              |   |   |   |
|             Accounts  receivable                                         |              | (21) |   | 35  |
|             Materials  and supplies                                      |              | (6) |   | (10) |
|             Other  current assets and due from Conrail                   |              | 49  |   | 51  |
|             Income  tax liabilities                                      |              |  35  |   | 27  |
|             Other  short-term liabilities                                |              | (17) |   | (61) |
|             Other  - net                                                 |              | (25) |   | (71) |
|                Net  cash provided by operating activities |              |  507  |   | 492  |
|                                                                                                                                 |              |   |   |   |
| ***Cash  flows from investing activities***                                                                                          |              |   |   |   |
|    Property  additions                                                                                                |              | (244) |   | (330) |
|    Property  sales and other transactions                                                                             |              |  10  |   | (10) |
|    Investments,  including short-term                                                                                 |              | (64) |   | (42) |
|    Investment  sales and other transactions                                                                           |              |  1  |   | --  |
|                Net  cash used for investing activities    |              | (297) |   | (382) |
|                                                                                                                                 |              |   |   |   |
| ***Cash  flows from financing activities***                                                                                          |              |   |   |   |
|    Dividends                                                                                                          |              | (1) |   | (1) |
|    Advances  to NS                                                                                                    |              | (339) |   | (334) |
|    Advances  and repayments from NS                                                                                   |              |  26  |   |  4  |
|    Proceeds  from borrowings                                                                                          |              |  130  |   | 198  |
|    Debt  repayments                                                                                                   |              | (80) |   | (97) |
|                Net  cash used for financing activities    |              | (264)  |   | (230) |
|                                                                                                                                 |              |   |   |   |
|                Net  decrease in cash and cash equivalents |              | (54) |   | (120) |
|                                                                                                                                 |              |   |   |   |
| ***Cash  and cash equivalents***                                                                                                     |              |   |   |   |
|    At  beginning of year                                                                                              |              |  130  |   | 167  |
|                                                                                                                                 |              |   |   |   |
|    At  end of period                                                                                                  | $                 |  76  | $ | 47  |
|  ******                                                                                                                         |              |   |
| ***Supplemental  disclosures of cash flow information***                                                                             |              |   |
|    Cash  paid during the period for:                                                                                  |              |   |   |   |
|       Interest  (net of amounts capitalized)                                                           | $                 | 21   | $ | 26  |
|       Income  taxes                                                                                    | $                 | 22   | $ | 35  |
|                                                                                                                                 |              |   |   |   |
| *See  accompanying notes to consolidated financial statements.*                                                                      |

 

5

**NORFOLK SOUTHERN RAILWAY COMPANY ANDSUBSIDIARIES**

**(A Majority-Owned Subsidiary of Norfolk SouthernCorporation [NS])**

**Notesto Consolidated Financial Statements**

**(Unaudited)**

 

 

In the opinion ofmanagement, the accompanying unaudited interim financial statements contain alladjustments (consisting of normal recurring accruals) necessary to present theCompany's financial position as of June 30, 2003, its results of operations forthe three and six months ended June 30, 2003 and 2002, and its cash flows forthe six months ended June 30, 2003 and 2002, in conformity with accountingprinciples generally accepted in the United States of America.

 

Althoughmanagement believes that the disclosures presented are adequate to make theinformation not misleading, these Consolidated Financial Statements should beread in conjunction with: (a) thefinancial statements and notes included in the Company's latest Annual Reporton Form 10-K and (b) any Current Reports on Form 8-K.

 

**1. Changes in Accounting Principles**

 

NS Rail adoptedFinancial Accounting Standards Board (FASB) Statement No. 143, "Accounting forAsset Retirement Obligations," (SFAS No. 143) effective Jan. 1, 2003, andrecorded a $100 million net adjustment ($165 million before taxes)for the cumulative effect of this change in accounting on years prior to2003. Pursuant to SFAS No. 143,the cost to remove crossties must be recorded as an expense when incurred;previously these removal costs were accrued as a component ofdepreciation. This change in accountinglowered depreciation expense by about $7 million in the second quarter and $14million in the first six months (because the depreciation rate for crossties nolonger reflects cost to remove) and increased compensation and benefits andother expenses by about $6 million for the quarter and $10 million for thefirst six months (for the costs to remove retired assets).

 

NS Rail also adoptedFASB Interpretation No. 46, "Consolidation of Variable Interest Entities," (FINNo. 46) effective Jan. 1, 2003, and recorded a $4 million net adjustment($6 million before taxes) for the cumulative effect of this change in accountingon years prior to 2003. Pursuant to FINNo. 46, NS Rail has consolidated a special-purpose entity that leases certainlocomotives to NS. This entity's assetsand liabilities at Jan. 1, 2003, included $169 million of locomotives and $157million of debt related to their purchase as well as a $6 million minorityinterest liability. This change inaccounting in the second quarter of 2003 increased depreciation and interestexpense (to reflect the locomotives as owned assets) and lowered lease expense. The net effect to total railway operatingexpenses and net income was not material.

 

**2. Related Parties**

 

## General

 

NSis the parent holding company of Norfolk Southern Railway Company (NSR). Rail operations are coordinated at theholding company level by the NS Vice Chairman and Chief Operating Officer. NS charges NS Rail a fee for managementservices it performs for NS Rail. Thisfee amounted to $146 million and $128 million in the second quarters of 2003and 2002, respectively (including a $10 million and $8 million mark-up in eachquarter, respectively) and $280 million and $274 million for the first sixmonths of 2003 and 2002, respectively (including an $18 million and $17 millionmark-up in each period, respectively). In addition, NS charges NS Rail a revenue-based licensing fee foruse of certain intangible assets owned by NS. This fee amounted to $25 million and $24 million in the second quartersof 2003 and 2002, respectively, and $46 million and $45 million for the firstsix months of 2003 and 2002, respectively.

 

NS Railowns 21,169,125 shares of NS common stock.

 

## Operations OverConrail's Lines

 

**Overview**-- Through a limited liability company, NS and CSX Corporation (CSX) jointlyown Conrail Inc. (Conrail), whose primary subsidiary is Consolidated RailCorporation (CRC), the major freight railroad in the

6

 

Northeast. NS has a 58% economic and 50% votinginterest in the jointly owned entity, and CSX has the remainder of the economicand voting interests.

 

NSRoperates as a part of its rail system the routes and assets of PennsylvaniaLines LLC (PRR), a wholly owned subsidiary of CRC, pursuant to operating andlease agreements. CSX Transportation,Inc. (CSXT) operates the routes and assets of another CRC subsidiary undercomparable terms.

 

**Operationsof Conrail's Lines** -- The June 1999 Operating Agreementbetween NSR and PRR governs substantially all track assets operated by NSRand has an initial 25-year term, renewable at the option of NSR for twofive-year terms. Payments under the Opera-tingAgreement are subject to adjustment every six years to reflect changes invalues. NSR also has leased orsubleased equipment for varying terms from PRR. Costs necessary to operate and maintain the PRR assets, includingleasehold improvements, are borne by NSR. NSR receives all freight revenues on the PRR lines.

 

NSR and CSXT also have entered into agreements withCRC governing other properties that continue to be owned and operated by CRC(the Shared Assets Areas). NSR and CSXTpay CRC a fee for joint and exclusive access to the Shared AssetsAreas. In addition, NSR and CSXT pay,based on usage, the costs incurred by CRC to operate the Shared Assets Areas.

 

**ProposedSpin-Off of PRR and NYC --**In June 2003, NS together with CSX andConrail, filed a joint petition with the Surface Transportation Board toestablish direct ownership and control by NSR and CSXT of PRR and NYC,respectively. The proposed transactionwould replace the existing operating agreements and allow NSR and CSXT tooperate PRR and NYC, respectively, via direct ownership. The proposed transaction does not involvethe Shared Assets Areas. The proposedtransaction is subject to a number of conditions, including STB approval and anInternal Revenue Service ruling qualifying it as a nontaxable distribution.

 

As a part of the proposed transaction, Conrailwould undertake a restructuring of its existing unsecured and secured publicindebtedness. There are currently twoseries of unsecured public debentures with an outstanding principal amount of$800 million and 13 series of secured debt with an outstanding principal amountof approximately $400 million. Itis currently contemplated that guaranteed debt securities of two newly formedcorporate subsidiaries of NSR and CSXT would be offered in a 58%/42% ratio inexchange for Conrail's unsecured debentures. Upon completion of the proposed transaction, the new debt securitieswould become direct unsecured obligations of NSR and CSXT, respectively, andwould rank equally with all existing and future senior unsecured debtobligations, if any, of NSR and CSXT. These new debt securities will have maturity dates, interest rates andprincipal and interest payment dates identical to those of the respectiveseries of Conrail's unsecured debentures. In addition, these new debt securities will have covenant packagessubstantially similar to those of the publicly traded debt securities of NS andCSX, respectively. Registrationstatements on Form S-4 will be filed with the U.S. Securities and ExchangeCommission in connection with the proposed exchange offer.

 

Conrail'ssecured debt and lease obligations will remain obligations of Conrail and areexpected to be supported by new leases and subleases which, upon completion ofthe proposed transaction, would be the direct lease and sublease obligations ofNSR or CSXT.

 

**Related-PartyTransactions with Conrail --**NS Rail providescertain general and administrative support functions to Conrail, the fees forwhich are billed in accordance with several service-provider arrangements andamount to approximately $7 million annually.

 

"Conrailrents and services" includes: (1)expenses for amounts due to PRR for use of operating properties and equipmentand (2) expenses for amounts due to CRC for operation of the Shared AssetsAreas.

 

Asignificant portion of payments made to PRR is borrowed back from a subsidiaryof PRR under a note due in 2032. Amounts outstanding under the note comprise the long-term balance of"Due to Conrail." Theinterest rate for these loans is variable and was 1.48% at June 30, 2003. The proposed spin-off transaction describedabove would effectively relieve NS Rail of this obligation. The current balance "Due toConrail" is composed of amounts related to expenses included in"Conrail rents and services," as discussed above.

 

7

 

NSRail's Consolidated Balance Sheet at June 30, 2003, includes $44 million ofliabilities related to the Conrail transaction, principally for contractualobligations to Conrail employees imposed by the Surface Transportation Boardwhen it approved the transaction. Through June 30, 2003, NS Rail has paid $139 million of such costs.

 

### Sales of Accounts Receivable

 

NSRail sells, without recourse, to a bankruptcy-remote special-purpose NSsubsidiary, a pool of accounts receivable. NS Rail services and collects all of the sold receivables on behalf ofthe buyers; however, no servicing asset or liability has been recognizedbecause the benefits of servicing are estimated to be just adequateto compensate NS Rail for its responsibilities. Payments collected from sold receivables are remitted to thespecial-purpose NS subsidiary, which, in turn, reinvests the amounts bypurchasing new receivables from NS Rail. NS Rail has no retained interest in the sold receivables.

 

Underthe terms of the new sale agreement, the receivables are treated as sold and,accordingly, $581 million at June 30, 2003, and $513 million at Dec. 31,2002, of sold receivables are not included on the NS Rail ConsolidatedBalance Sheets. Fees associated withthe sale, which are based on historical dilution and prevailing interest rates,are included in "Other income (expense) - net."

** **

**IntercompanyAccounts**

 

|                                      | **June  30, 2003** | **Dec.  31, 2002** |
|-------------------------------------------|--------------------|--------------------|
|                                      |  ****         |  ****         | **Average** |  **** |  **** | Average |
|                                      |  ****         |  ****         | **Interest** |  **** |  **** | **Interest** |
|                                      | **Balance**        | **Rate**           | **Balance** | **Rate** |
|                                      | *($  in millions)* |
|                                      |               |               |   |   |   |   |
|   Advances  due from NS         | $                  | 68            | 2% | $ | 68  | 2% |
|                                      |               |               |   |   |   |   |
|   Advances  and notes due to NS |               | (457)              | 2% |   | (452) | 2% |
|                                      |               |               |   |   |   |   |
|   Due  to NS - net              | $                  | (389)              |   | $ | (384) |   |

 

Interest is applied tocertain advances at the average NS yield on short-term investments and to thenotes at specified rates. NS Rail'sresults for the six months ended June 30 include interest income of $5 millionin 2003 and in 2002 and interest expense of $4 million in 2003 and $5 millionin 2002 related to these intercompany accounts. These amounts are included in "Other income (expense) -net."

 

**NoncashDividend**

 

NS Rail declared andissued to NS a noncash dividend of $317 million in June 2003, which was settledby reduction of NS Rail's interest-bearing advances due from NS. Noncash dividends are excluded from theConsolidated Statements of Cash Flows.

 

### Intercompany Federal Income Tax Accounts

 

Inaccordance with the NS Tax Allocation Agreement, intercompany federal incometax accounts are recorded between companies in the NS consolidated group. NS Rail had long-term intercompanyfederal income tax payables (which are included in "Deferred incometaxes" in the Consolidated Balance Sheets) of $963 million at June30, 2003, and $938 million at Dec. 31, 2002.

 

**3. Derivative Financial Instruments**

 

NSRail uses derivative financial instruments to reduce the risk of volatility inits diesel fuel costs and to manage its overall exposure to fluctuations ininterest rates. NS Rail does not engagein the trading of derivatives. NSRail's management has determined that its derivative financial instrumentsqualify as either fair-value or cash-flow hedges, having values which highlycorrelate with the underlying hedged exposures, and has designated suchinstruments as hedging transactions. Credit risk related to the derivative financial instruments isconsidered to be minimal and is managed by requiring high credit standards forcounterparties and periodic settlements.

 

8

 

**DieselFuel Hedging**

 

In the second quarter of 2001, NS Rail began aprogram to hedge a portion of its diesel fuel consumption. The intent of theprogram is to assist in the management of NS Rail's aggregate risk exposure tofuel price fluctuations, which can significantly affect NS Rail's operatingmargins and profitability. In order tominimize this risk, NS Rail instituted a continuous hedging strategy for aportion of its estimated future fuel needs by entering into a series of swapsin order to lock in the purchase prices of some of its diesel fuel. Management has designated these derivativeinstruments as cash-flow hedges of the exposure to variability in expectedfuture cash flows attributable to fluctuations in diesel fuel prices.

 

Following is a summary of NS Rail's dieselfuel swaps:

 

|                                                                                                     |              | Second  quarter |
|----------------------------------------------------------------------------------------------------------|-------------------|-----------------|
|                                                                                                     |              | **2003**        | **2002** |
| Number of swaps entered into during the second  quarter                                                  |              | 72              | 72 |
| Approximate number of gallons hedged  (millions)                                                         |              | 94              | 98 |
| Approximate average price per gallon of Nymex                                                            |              |  $0.70     |  $0.67 |
|    No. 2 heating oil                                                                      |              |            |   |
|                                                                                                     | **Remainder  of** |            |   |
|                                                                                                     | **2003**          | **2004**        | **2005** |
| Percent of estimated future diesel  fuel consumption

   covered as of June 30, 2003 | 72%               | 43%             | 6% |
|                                                                                                          |                   |                 |  |  |  |

 

Hedges are placed each month by competitive bidamong selected counterparties. The goal of this hedging strategy is to averagefuel costs over an extended period of time while minimizing the incrementalcost of hedging. The program providesthat NS Rail will not enter into any fuel hedges with a duration of more than36 months, and that no more than 80% of NS Rail's average monthly fuelconsumption will be hedged for any month within the 36-month period. Dieselfuel costs represented 7% of NS Rail's operating expenses for the secondquarters of 2003 and 2002.

 

NS Rail's fuel hedgingactivity had the following effects on diesel fuel expense: for the second quarter, decreases of $8million and $1 million for 2003 and 2002, respectively, and for the first sixmonths, a decrease of $34 million and an increase of $3 million for 2003 and2002, respectively. The effect of thehedges was to yield average costs per gallon (including federal taxes andtransportation) of 80 cents and 70 cents for the second quarters of 2003 and2002, respectively, and 83 cents and 69 cents for the first six months of 2003and 2002, respectively. Ineffectiveness, or the extent to which changes in the fair values ofthe heating oil contracts do not offset changes in the fair values of theexpected diesel fuel oil transactions, was approximately $1 million for eachquarter.

 

**Interest Rate Hedging**

 

NSRail manages its overall exposure to fluctuations in interest rates by issuingboth fixed and floating-rate debt instruments, and by entering into interestrate hedging transactions. NS Rail had$203 million, or 35.0%, and $220 million, or 35.4%, of its fixed rate debtportfolio hedged at June 30, 2003, and Dec. 31, 2002, respectively, usinginterest rate swaps that qualify for and are designated as fair-value hedgetransactions. These swaps have beeneffective in hedging the changes in fair value of the related debt arising fromchanges in interest rates, and accordingly, there has been no impact onearnings resulting from ineffectiveness associated with these derivativetransactions.

** **

**FairValues**

 

Thefair values of NS Rail's diesel fuel derivative instruments at June 30, 2003and Dec. 31, 2002, were determined based upon current fair market values asquoted by third party dealers. Fairvalues of interest rate swaps were determined based upon the present value ofexpected future cash flows discounted at the appropriate implied spot rate fromthe spot rate yield curve. Fair valueadjustments are non-cash transactions, and accordingly, are excluded from theConsolidated Statement of Cash Flows. "Accumulatedother comprehensive loss," a component of "Stockholders'equity," included unrealized gains of $29 million (pretax) at June 30,2003, and at Dec. 31, 2002,

 

9

 

relatedto the fair value of derivative fuel hedging transactions that will terminatewithin twelve months of the respective dates.

 

The asset andliability positions of NS Rail's outstanding derivative financial instrumentswere as follows:

 

|                                                | **June  30,**      | **Dec.  31,** |
|-----------------------------------------------------|--------------------|---------------|
|                                                | **2003**           | **2002**      |
|                                                | *($  in millions)* |
| Interest rate hedges:                               |               |          |   |   |
|   Gross fair market asset position        | $                  | 24            | $ | 24  |
|   Gross fair market (liability)  position |               | --            |   | --  |
|                                                |               |          |   |   |
| Fuel hedges:                                        |               |          |   |   |
|   Gross fair market asset position        |               | 32            |   | 29  |
|   Gross fair market (liability)  position |               | --            |   | --  |
|                                                |               |          |   |   |
| Total net asset position                            | $                  | 56            | $ | 53  |

 

**4. Comprehensive Income**

 

 

NS Rail'stotal comprehensive income was as follows:

 

|                               | **Three  months Ended** | Six months Ended |
|------------------------------------|-------------------------|------------------|
|                               | **June  30,**           | **June  30,**    |
|                               | **2003**                | **2002**         | **2003** | **2002** |
|                               | *($  in millions)*      |
|                               |                    |             |   |   |   |   |   |   |
| Net  income                        | $                       | 108              | $ | 126  | $ | 292  | $ | 211  |
| Other  comprehensive income (loss) |                    | 13               |   | (10) |   | (7) |   | 85  |
|                               |                    |             |   |   |   |   |   |   |
| Total  comprehensive income        | $                       | 121              | $ | 116  | $ | 285  | $ | 296  |

 

"Othercomprehensive income (loss)" is the unrealized gains and losses on certaininvestments in debt and equity securities, principally NS common stock, and netfair value adjustments to certain derivative financial instruments.

 

**5. Commitments and Contingencies**

 

**Lawsuits**

 

NSR and certainsubsidiaries are defendants in numerous lawsuits and other claims relatingprincipally to railroad operations. When management concludes that it is probable that a liability has beenincurred and the amount of the liability can be reasonably estimated, it isaccrued through a charge to expenses. While the ultimate amount of liability incurred in any of these lawsuitsand claims is dependent on future developments, in management's opinion therecorded liability is adequate to cover the future payment of such liabilityand claims. However, the final outcomeof any of these lawsuits and claims cannot be predicted with certainty, andunfavorable or unexpected outcomes could result in additional accruals thatcould be significant to results of operations in a particular year orquarter. Any adjustments to recordedliability will be reflected in expenses in the periods in which suchadjustments are known.

 

Presently,there are claims for "New York Dock" and other income protectionbenefits where the aggregated range of loss could be from zero to $20million. Several hundred claims havebeen filed with NSR on behalf of employees furloughed after June 1, 1999,for various periods of time, alleging that the furloughs were a result of theConrail transaction and seeking "New York Dock" income protectionbenefits. Several labor organizationshave initiated arbitration on behalf of individual employees. Two significant cases have been heard. Both resulted in an award favorable to NSR. Other disputes are pending wherein similarbenefits are sought under labor agreement provisions that, in management'sjudgment, do not apply to the involved circumstances. Management believes that NS Rail will prevail in these matters;however, an unfavorable outcome could result in accruals that could besignificant to results of operations in a particular year or quarter.

 

10

 

**Casualty Claims**

 

NSRail is generally self-insured for casualty claims. NS Rail has insurance for catastrophic events, but that coveragehas upper limits. The casualty claims liability is determined actuarially,based upon claims filed and an estimate of claims incurred but not yetreported. While the ultimate amount ofclaims incurred is dependent on future developments, in management's opinion,the recorded liability is adequate to cover the future payments of claims. However, it is possible that the recordedliability may not be adequate to cover the future payments of claims. Adjustments to the recorded liability arereflected in operating expenses in the periods in which such adjustments areknown.

 

**Environmental Matters**

 

NSRail is subject to various jurisdictions' environmental laws andregulations. It is NS Rail's policy torecord a liability where such liability or loss is probable and its amount canbe estimated reasonably. Claims, ifany, against third parties for recovery of cleanup costs incurred by NS Railare reflected as receivables (when collection is probable) in the balance sheetand are not netted against the associated NS Rail liability. Environmental engineers regularlyparticipate in ongoing evaluations of all identified sites and in determiningany necessary adjustments to liability estimates. NS Rail also has established an Environmental Policy Council,composed of senior managers, to oversee and interpret its environmental policy.

 

NSRail's balance sheets included liabilities for environmental exposures in theamount of $24 million at June 30, 2003, and $29 million at Dec. 31, 2002 (ofwhich $8 million was accounted for as a current liability for eachperiod). At June 30, 2003, theliability represented NS Rail's estimate of the probable cleanup andremediation costs based on available information at 110 identifiedlocations. On that date, 10 sites accountedfor $13 million of the liability, and no individual site was considered to bematerial. NS Rail anticipates that muchof this liability will be paid out over five years; however, some costs will bepaid out over a longer period.

 

Atsome of the 110 locations, certain NS Rail subsidiaries, usually in conjunctionwith a number of other parties, have been identified as potentially responsibleparties by the Environmental Protection Agency (EPA) or similar stateauthorities under the Comprehensive Environmental Response, Compensation andLiability Act of 1980, or comparable state statutes, which often impose jointand several liability for cleanup costs.

 

Withrespect to known environmental sites (whether identified by NS Rail or by theEPA or comparable state authorities), estimates of NS Rail's ultimate potentialfinancial exposure for a given site or in the aggregate for all such sites arenecessarily imprecise because of the widely varying costs of currentlyavailable cleanup techniques, the likely development of new cleanuptechnologies, the difficulty of determining in advance the nature and fullextent of contamination and each potential participant's share of any estimatedloss (and that participant's ability to bear it) and evolving statutory andregulatory standards governing liability.

 

Therisk of incurring environmental liability -- for acts and omissions, past,present and future -- is inherent in the railroad business. Some of the commodities in NS Rail's trafficmix, particularly those classified as hazardous materials, can pose specialrisks that NS Rail and its subsidiaries work diligently to minimize. In addition, several NS Rail subsidiariesown, or have owned, land used as operating property, or which is leased or mayhave been leased and operated by others, or held for sale. Because environmental problems may exist onthese properties that are latent or undisclosed, there can be no assurance thatNS Rail will not incur environmentally related liabilities or costs withrespect to one or more of them, the amount and materiality of which cannot beestimated reliably at this time. Moreover, lawsuits and claims involving these and potentially othernow-unidentified environmental sites and matters are likely to arise from timeto time. The resulting liabilitiescould have a significant effect on financial condition, results of operationsor liquidity in a particular year or quarter.

 

However,based on its assessments of the facts and circumstances now known, managementbelieves that it has recorded the probable costs for dealing with thoseenvironmental matters of which the Corporation is aware. Further, management believes that it isunlikely that any identified matters, either individually or in the aggregate,will have a material adverse effect on NS Rail's financial position, results ofoperations or liquidity.

 

11

 

**Purchase Commitments**

 

AtJune 30, 2003, NS Rail had outstanding purchase commitments of approximately$15 million in connection with its 2003 capital program.

 

 

**Independent Accountants' Review Report**

 

 

The Stockholders and Board of Directors

Norfolk Southern Railway Company:

 

We have reviewed theaccompanying consolidated balance sheet of Norfolk Southern Railway Company andsubsidiaries as of June 30, 2003, and the related consolidated statements ofincome for the three-month and six-month periods ended June 30, 2003 and 2002and the related consolidated statements of cash flows for the six-month periodsended June 30, 2003 and 2002. Theseconsolidated financial statements are the responsibility of the Company'smanagement.

 

We conducted ourreviews in accordance with standards established by the American Institute ofCertified Public Accountants. A reviewof interim financial information consists principally of applying analyticalprocedures and making inquiries of persons responsible for financial andaccounting matters. It is substantiallyless in scope than an audit conducted in accordance with auditing standardsgenerally accepted in the United States of America, the objective of which isthe expression of an opinion regarding the financial statements taken as awhole. Accordingly, we do not expresssuch an opinion.

 

Based on our reviews,we are not aware of any material modifications that should be made to theconsolidated financial statements referred to above for them to be inconformity with accounting principles generally accepted in the United Statesof America. 

 

As discussed in Note 1to the consolidated financial statements, the Company adopted Financial AccountingStandards Board Statement No. 143, *Accounting for Asset RetirementObligations,* and Financial Accounting Standards Board Interpretation No.46, *Consolidation of Variable Interest Entities,* as of January 1, 2003.

 

We have previouslyaudited, in accordance with auditing standards generally accepted in the UnitedStates of America, the consolidated balance sheet of Norfolk Southern RailwayCompany and subsidiaries as of December 31, 2002, and the related consolidatedstatements of income, changes in stockholders' equity and cash flows for theyear then ended (not presented herein); and in our report dated January 28,2003, we expressed an unqualified opinion on those consolidated financialstatements. In our opinion, theinformation set forth in the accompanying consolidated balance sheet as ofDecember 31, 2002, is fairly stated, in all material respects, in relation tothe consolidated balance sheet from which it has been derived.

 

 

 

/s/ KPMG LLP

Norfolk, Virginia

July 22, 2003

 

12

**Item 2. Management's Discussion and Analysis of Financial Condition and Resultsof Operations.**

** **

** **

**NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES**

**(A M****ajority-OwnedSubsidiary of Norfolk Southern Corporation [NS])**

**Management'sDiscussion and Analysis of Financial Condition and Results of Operations**

** **

** **

**RESULTS OF OPERATIONS**

 

### Net Income

 

Second-quarter netincome was $108 million in 2003, down $18 million, or 14%, compared with thesame period last year. For the firstsix months of 2003, net income was $292 million and included $104 million forthe cumulative effect on years prior to 2003 of changes in accountingprinciples as required by the adoption of two accounting pronouncements (seeNote 1). Six-month income beforeaccounting changes was $188 million, down $23 million, or 11%, compared withresults for the same period of 2002. The declines for both the quarter and first six months were primarilythe result of lower income from railway operations.

 

### Railway Operating Revenues

 

Second-quarter railway operatingrevenues were $1.6 billion in 2003, up $42 million, or 3%, compared with thesecond quarter of last year. For thefirst six months, revenues were $3.1 billion, up $104 million, or 3%. As shown in the following table, theincreases were the result of higher traffic volume and increased averagerevenues.

 

|                                | Second  quarter                        | **First  six months**                  |
|-------------------------------------|----------------------------------------|----------------------------------------|
|                                | **2003  vs. 2002**                     | **2003  vs. 2002**                     |
|                                | **Increase  (Decrease)**               | **Increase  (Decrease)**               |
|                                | *($ in millions)*                      |
|                                |                                   |                                   |
| Traffic volume (carloads)           | $    17            | $    55            |
| Revenue per unit/mix                |       25 |       49 |
|      Total | $    42            | $   104                 |

 

Revenues,carloads and average revenue per unit for the commodity groups were as follows(prior year amounts have been reclassified to conform to the currentpresentation):

 

|                                         | **Second  Quarter** |
|----------------------------------------------|---------------------|
|                                         | **Revenue**         | **Carloads** | **Revenue  per Unit** |
|                                         | **2003**            | **2002** | **2003** | **2002** | **2003** | **2002** |
|                                         | *($  in millions)*  | *(in  thousands)* | *($  per unit)* |
|                                         |                |   |   |   |   |   |   |   |   |   |   |   |
| Coal                                         | $                   | 389 | $ | 350 |   | 420 |   | 394 | $ | 927 | $ | 889 |
| General merchandise:                         |                |   |   |   |   |   |   |   |   |   |   |   |
|    Automotive                 |                | 242 |   | 259 |   | 169 |   | 181 |   | 1,433 |   | 1,428 |
|    Chemicals                  |                | 190 |   | 190 |   | 105 |   | 108 |   | 1,809 |   | 1,771 |
|    Metals/construction        |                | 175 |   | 189 |   | 184 |   | 196 |   | 954 |   | 966 |
|    Agr./consumer  prod./govt. |                | 175 |   | 156 |   | 137 |   | 127 |   | 1,278 |   | 1,227 |
|    Paper/clay/forest          |                | 162 |   | 154 |   | 113 |   | 112 |   | 1,433 |   | 1,376 |
|                                         |                |   |   |   |   |   |   |   |   |   |   |   |
| General  merchandise                         |                | 944 |   | 948 |   | 708 |   | 724 |   | 1,334 |   | 1,310 |
| Intermodal                                   |                | 256 |   | 249 |   | 608 |   | 599 |   | 421 |   | 417 |
|                                         |                |   |   |   |   |   |   |   |   |   |   |   |
|       Total    | $                   | 1,589 | $ | 1,547 |   | 1,736 |   | 1,717 | $ | 916 | $ | 902 |

 

13

|                                         | **First  Six Months** |
|----------------------------------------------|-----------------------|
|                                         | Revenues              | **Carloads** | **Revenue  per Unit** |
|                                         | **2003**              | **2002** | **2003** | **2002** | **2003** | **2002** |
|                                         | *($  in millions)*    | *(in  thousands)* | *($  per unit)* |
|                                         |                  |   |   |   |   |   |   |   |   |   |   |   |
| Coal                                         | $                     | 743 | $ | 709 |   | 816 |   | 792 | $ | 911 | $ | 895 |
| General  merchandise:                        |                  |   |   |   |   |   |   |   |   |   |   |   |
|    Automotive                 |                  | 484 |   | 487 |   | 335 |   | 344 |   | 1,443 |   | 1,414 |
|    Chemicals                  |                  | 382 |   | 373 |   | 211 |   | 209 |   | 1,816 |   | 1,784 |
|    Metals/construction        |                  | 341 |   | 349 |   | 345 |   | 358 |   | 988 |   | 977 |
|    Agr./consumer  prod./govt. |                  | 343 |   | 313 |   | 271 |   | 255 |   | 1,262 |   | 1,231 |
|    Paper/clay/forest          |                  | 312 |   | 295 |   | 220 |   | 217 |   | 1,419 |   | 1,358 |
|                                         |                  |   |   |   |   |   |   |   |   |   |   |   |
| General  merchandise                         |                  | 1,862 |   | 1,817 |   | 1,382 |   | 1,383 |   | 1,347 |   | 1,314 |
| Intermodal                                   |                  | 503 |   | 478 |   | 1,186 |   | 1,148 |   | 424 |   | 416 |
|                                         |                  |   |   |   |   |   |   |   |   |   |   |   |
|       Total    | $                     | 3,108 | $ | 3,004 |   | 3,384 |   | 3,323 | $ | 918 | $ | 904 |

 

**Coal**

 

Coal revenuesincreased $39 million, or 11%, in the second quarter and $34 million, or5%, in the first six months, compared with the same periods last year. Total traffic volume (tonnage) handledincreased 8% in the quarter and 4% for the first six months, primarily becauseof higher utility coal volume. Shipments of utility coal increased 9% in the quarter as stockpilereplenishments, increased coal-fired generation and gains from new businessmore than offset the effects of reduced demand for electricity. Utility coal volume was up 5% for the firstsix months, largely due to the second-quarter increase. Export coal volume increased 19% in thequarter and 6% for the first six months. Both increases were primarily the result of increased shipments ofmetallurgical coal, which more than offset less steam coal exports. Average revenue per carload was up 4% in thesecond quarter and 2% for the first six months, reflecting a favorable changein the mix of traffic (the rate of increase in longer haul traffic exceededthat of shorter haul traffic) and the favorable effects of a fuel surcharge.

 

For the remainder of the year, coal volumes areexpected to continue to be higher, although mild weather patterns could dampenthis outlook. While utility stockpilesare estimated to be near target levels, significant natural gasprice increases are expected this winter, which could lead to greaterutilization of coal-fired generation plants. As disclosed in NS Rail's 2002 10-K, since early 2002, two utilitycustomers have rate reasonableness complaints before the Surface TransportationBoard (STB). Until resolved, NS Rail isbilling and collecting amounts from these customers based on the challengedtariff rates. NS Rail currently expectsthe STB to issue its decisions in the fourth quarter of 2003, although ultimateresolution may not occur until a later date. While the accompanying financial statements reflect management's bestestimate of the resolution of these matters, due to the passage of time, theirultimate outcome could have a significant effect on results of operations inthe particular quarter or year resolved.

 

### General Merchandise

 

Generalmerchandise revenues decreased $4 million in the second quarter, but increased$45 million, or 2%, in the first six months, compared with the sameperiods last year. The slight declinefor the quarter was the result of lower traffic volume (carloads), which waslargely offset by higher average revenues. For the first six months, the revenue increase reflected higher averagerevenues as traffic volume was flat. For both periods, the largest volume decreases were in the metals andconstruction and automotive groups. Metals and construction volume suffered from continued softness in the importedsteel market and a weak U.S. dollar. Automotive traffic volume reflected reduced production from Ford,General Motors and DaimlerChrysler, which was partially offset by increasedshipments for Toyota, BMW and Honda. Agriculture, consumer products and government volume increased 8% in thequarter and 7% for the first six months reflecting more shipments of corn intomarkets affected by the 2002 drought. This is expected to continue until late September when the 2003 cropcomes to market. In addition, trafficvolume benefited from increased volume for fertilizer and more shipments forthe military. Paper, clay and forestproducts volume increased 1% for both the quarter and first six months,supported by improving market conditions and diversion of truck traffic torail.

 

14

 

General merchandise average revenue per carloadincreased 2% in the second quarter and 3% for the first six months reflectingfuel surcharges, increased rates and longer lengths of haul.

 

General merchandise revenues areexpected to continue to show weakness during the last half of the year and arelargely dependent upon the performance of the economy.

 

### Intermodal

 

Intermodalrevenues increased $7 million, or 3%, in the second quarter and$25 million, or 5%, in the first six months, compared with the sameperiods last year. Traffic volume(units) increased 1% in the second quarter and 3% for the first six monthsreflecting more shipments of containers, which offset declines in premium business(mostly postal traffic and automotive parts). Container traffic volume benefited from increased international anddomestic truckload business as well as the conversion of truck traffic torail. Intermodal revenue per unitincreased 1% for the quarter and 2% for the first six months, as the favorableeffects of fuel surcharges and ancillary revenues more than offset anunfavorable change in the mix of traffic.

 

Intermodal revenuesare expected to continue to benefit from new business supported by continuedimprovements in service and conversion of truck traffic to rail; however, anyweakening in consumer demand could dampen this outlook.****

 

### Railway Operating Expenses

 

Second-quarter railway operating expenses were$1.3 billion in 2003, up $73 million, or 6%, compared with last year. For the first six months, expenses were$2.7 billion, up $146 million, or 6%. For both periods, most expense line items were higher.

 

As discussed in Note 1, effective Jan. 1, 2003,NS Rail's method of accounting for crosstie removal was changed as a result ofimplementation of SFAS No. 143. Thischange in accounting lowered depreciation expense and increased compensationand benefits and other expenses as disclosed in Note 1. For the year, it is expected that thedepreciation reduction will total approximately $29 million, while the expenseincreases will total about $20 million.

 

Compensation and benefits expenses increased $24million, or 6%, in the second quarter and $41 million, or 5%, in the firstsix months, compared with the same periods last year. Both comparisons reflected lower pension income, higher wagerates, increased medical costs (despite additional employee contributions),expenses attributable to employee turnover (more train and engine trainees) andthe effect of the change in accounting (see Note 1). These increases more than offset reduced payroll taxes.

 

Materials,services and rents increased $33 million, or 7%, in the second quarter and$39 million, or 4%, in the first six months, compared with the sameperiods last year. Both increases wereprimarily the result of higher expenses for the management fee charged by NS(see Note 2), repairs and maintenance, haulage and software license andmaintenance fees.

 

Conrail rents and services expenses increased $3million, or 3%, in the second quarter and $1 million in the first sixmonths, compared with the same periods last year. The increases were principally the result of higher OperatingAgreement fees, which, for the first six months, were largely offset by lowerexpenses in the Shared Assets Areas.

 

Depreciation expense was down slightly in boththe second quarter and the first six months, compared with the same periodslast year, as the effects of property additions were offset by the change inaccounting related to crosstie removal costs (see Note 1). 

 

Diesel fuel expenses increased $9 million, or11%, in the second quarter and $32 million, or 19%, in the first sixmonths, compared with the same periods last year, reflecting higher averageprices and marginally lower consumption. The hedging program produced benefits of $8 million and$34 million in the second quarter and first six months of 2003, comparedwith a $1 million benefit and $3 million of cost for the same periodsof 2002, respectively.

 

Casualties and other claims expense increased$11 million, or 30%, in the second quarter and $27 million, or 38%,in the first six months, compared with the same periods last year. The increases were largely the result ofcontinuing

 

15

 

adverse personal injury claims development andhigher insurance premiums, which was mitigated by an insurance recovery relatedto a previous settlement. The increasefor the first six months also reflected damage costs incurred because ofseveral derailments early in the year.

 

Other expensedecreased $5 million, or 6%, in the second quarter, but increased$8 million, or 6%, in the first six months, compared with the same periodsof last year. The decline resulted froma favorable property tax settlement, while the increase reflected the absenceof a favorable bad debt settlement (the effects of this year's property taxsettlement was comparable to a similar item in the first quarter of 2002).

 

** **

**FINANCIAL CONDITION AND LIQUIDITY**

 

Cash provided byoperating activities, NS Rail's principal source of liquidity, was $507 millionin the first six months of 2003, compared with $492 million in the first sixmonths of 2002. The increase wasprimarily the result of favorable changes in working capital.

 

A significant portionof payments made to PRR (which are included in "Conrail rents andservices" and, therefore, are a use of cash in "Cash provided byoperating activities") are borrowed back from a PRR subsidiary and,therefore, are a source of cash in "Proceeds from borrowings." NS Rail's net cash flow from these borrowingsamounted to $105 million in the first six months of 2003 and $98 million forthe same period of 2002.

 

NS Rail's workingcapital deficit was $1.1 billion at June 30, 2003, and at Dec. 31, 2002.

 

NS Rail looks to NS toprovide needed funding. NS currentlyhas the capability to increase the amount of accounts receivable being soldunder the revolving sale program. Overthe last twelve months, the amount of receivables NS could sell under thisprogram ranged from $358 million to $422 million, and the amount of receivablesNS sold ranged from zero to $200 million. Moreover, NS has a $1 billion creditfacility, which expires in 2006, that it can borrow under or use to supportcommercial paper debt; however, reductions in its credit rating could limit NS'ability to access the commercial paper markets.

 

As the major NSsubsidiary, NS Rail provides funding to service NS' debt. NS' debt at June 30, 2003, totaled $6.4billion. Of this debt, $1.8 billion isdue between 2003 and 2007.

 

NS Rail expects togenerate sufficient cash flow from operations to meet its ongoing obligations,as well as to advance amounts to NS to service its debt.

 

Cash used forinvesting activities decreased in the first six months of 2003, compared withthe first six months of 2002, principally because of a decline in capitalexpenditures. The decrease reflectedthe absence of locomotive purchases in 2003; however, NS Rail expects toacquire locomotives later in the year.

 

Cash used forfinancing activities was $264 million in the first six months of 2003, comparedwith $230 million in the same period of 2002, reflecting the absence in 2003 ofproceeds from equipment financing. Advances to NS typically account for most ofthe cash used for financing activities and reflect NS' requirements.

** **

** **

**OTHER MATTERS**

** **

**LaborArbitration**

 

Severalhundred claims have been filed with NSR on behalf of employees furloughed afterJune 1, 1999, for various periods of time, alleging that the furloughswere a result of the Conrail transaction and seeking "New York Dock"income protection benefits. Severallabor organizations have initiated arbitration on behalf of individualemployees. Two significant cases havebeen heard. Both resulted in an awardfavorable to NSR. Other disputes arepending wherein similar benefits are sought under labor agreement provisionsthat, in management's judgment, do not apply to the involvedcircumstances. Based on known facts,including the availability of legal defenses, management believes that NS Railwill prevail in these disputes and that any potential liability for theinvolved claims should not have a material adverse effect on NS Rail'sfinancial position, results of operations or liquidity.

 

16

 

Dependingon the outcome of these arbitrations and claims, other claims may be filed orprogressed to arbitration. Should allsuch claimants prevail, there could be a significant effect on results ofoperations in a particular quarter (see Note 5).

 

**LaborAgreements**

 

Approximately24,000 of NS Rail's employees are covered by collective bargaining agreementswith 15 different labor unions. Theseagreements remain in effect until changed pursuant to the Railway LaborAct. Moratorium provisions in theseagreements permitted NS Rail and the unions to propose such changes in late1999; negotiations at the national level commenced shortly thereafter. Agreements have been reached with theBrotherhood of Maintenance of Way Employes (BMWE), which represents about 4,200NS Rail employees; the Brotherhood of Locomotive Engineers (BLE), whichrepresents about 4,500 NS Rail employees; the United Transportation Union(UTU), which represents about 6,700 NS Rail employees; the InternationalBrotherhood of Boilermakers and Blacksmiths (IBB), which represents about 100NS Rail employees; the Transportation Communications International Union (TCU),which represents about 4,400 NS Rail employees; and the American TrainDispatchers Department (ATDD), which represents about 400 NS Railemployees. A tentative agreement(subject to ratification) has also been reached with the Brotherhood of RailwaySignalmen (BRS), which represents about 1,100 NS Rail employees. The agreement previously reached with theBLE was through 2004; NS Rail recently reached a further contract extensionwith the BLE through 2009 (subject to ratification). Health and welfare issues were resolved by the BMWE and TCUagreements (and by the tentative BRS agreement). The UTU agreement provides that, subsequent to a further periodof negotiation, health and welfare issues may be submitted to arbitration. Health and welfare issues with the otherorganizations have not yet been resolved.

 

**MarketRisks and Hedging Activities**

 

NS Rail uses derivative financial instruments toreduce the risk of volatility in its diesel fuel costs and to manage itsoverall exposure to fluctuations in interest rates.

 

In 2001, NS Rail began a program to hedge a portionof its diesel fuel consumption. Theintent of the program is to assist in the management of NS Rail's aggregaterisk exposure to fuel price fluctuations, which can significantly affect NSRail's operating margins and profitability, through the use of one or moretypes of derivative instruments.

 

Diesel fuel costs represented 7% of NS Rail'soperating expenses for the second quarter of 2003. The program provides that NS Rail will not enter into any fuelhedges with a duration of more than 36 months, and that no more than 80% of NSRail's average monthly fuel consumption will be hedged for any month within any36-month period.

 

As of June 30, 2003, through swap transactions, NSRail has hedged approximately 72% of expected diesel fuel requirements for theremainder of 2003, and 43% and 6% of expected requirements for 2004 and 2005,respectively. The effect of the hedgesis to yield an average cost of 76 cents per hedged gallon for the rest of2003, including federal taxes and transportation. A 10% decrease in diesel fuel prices would reduce NS Rail's assetrelated to the swaps by approximately $30 million as of June 30, 2003.

 

NSRail manages its overall exposure to fluctuations in interest rates by issuingboth fixed- and floating-rate debt instruments and by entering intointerest-rate hedging transactions to achieve an appropriate mix within itsdebt portfolio.

 

At June 30, 2003, NSRail's debt subject to interest rate exposure totaled $557 million. A 1 percentage point increase in interestrates would increase NS Rail's total annual interest expense related to all itsvariable debt by approximately $6 million. Management considers it unlikely that interest rate fluctuationsapplicable to these instruments will result in a material adverse effect on NSRail's financial position, results of operations or liquidity.

 

Some of NS Rail'scapital leases, which carry an average fixed rate of 7%, were effectivelyconverted to variable rate obligations using interest rate swapagreements. On June 30, 2003, theaverage pay rate under these agreements was 2%, and the average receive ratewas 7%. The effect of the swaps was toreduce interest expense by $2 million in both the second quarters of 2003 and2002 and by $4 million and $5 million for the first six months of 2003 and2002, respectively. A portion of thelease obligations is payable in Japanese yen. NS Rail

 

17

 

eliminated theassociated exchange rate risk at the inception of each lease with a yen depositsufficient to fund the yen-denominated obligation. Most of these deposits are held by foreign banks, primarilyJapanese. As a result, NS Rail isexposed to financial market risk relative to Japan. Counterparties to the interest rate swaps and Japanese banksholding yen deposits are major financial institutions believed by management tobe creditworthy.

** **

**EnvironmentalMatters**

 

NSRail is subject to various jurisdictions' environmental laws andregulations. It is NS Rail's policy torecord a liability where such liability or loss is probable and its amount canbe estimated reasonably. Claims, ifany, against third parties for recovery of cleanup costs incurred by NS Railare reflected as receivables (when collection is probable) in the balance sheetand are not netted against the associated NS Rail liability. Environmental engineers regularlyparticipate in ongoing evaluations of all known sites and in determining anynecessary adjustments to liability estimates. NS Rail also has established an Environmental Policy Council, composedof senior managers, to oversee and interpret its environmental policy.

 

Operatingexpenses for environmental matters totaled approximately $2 million for thefirst six months of 2003 and $5 million for the same period of 2002. Capital expenditures totaled approximately$2 million and $3 million for the first six months of 2003 and 2002,respectively.

 

NSRail's balance sheets included liabilities for environmental exposures in theamount of $24 million at June 30, 2003, and $29 million at Dec. 31, 2002 (ofwhich $8 million was accounted for as a current liability in each period). At June 30, 2003, the liability representedNS Rail's estimate of the probable cleanup and remediation costs based onavailable information at 110 known locations. On that date, 10 sites accounted for $13 million of the liability, andno individual site was considered to be material. NS Rail anticipates that much of this liability will be paid outover five years; however, some costs will be paid out over a longer period.

 

Atsome of the 110 locations, certain NS Rail subsidiaries, usually in conjunctionwith a number of other parties, have been identified as potentially responsibleparties by the Environmental Protection Agency (EPA) or similar stateauthorities under the Comprehensive Environmental Response, Compensation andLiability Act of 1980, or comparable state statutes, which often impose jointand several liability for cleanup costs.

 

Withrespect to known environmental sites (whether identified by NS or by the EPA orcomparable state authorities), estimates of NS Rail's ultimate potentialfinancial exposure for a given site or in the aggregate for all such sites areunavoidably imprecise because of the widely varying costs of currentlyavailable cleanup techniques, the likely development of new cleanuptechnologies, the difficulty of determining in advance the nature and fullextent of contamination and each potential participant's share of any estimatedloss (and that participant's ability to bear it), and evolving statutory andregulatory standards governing liability.

 

Therisk of incurring environmental liability -- for acts and omissions, past,present and future -- is inherent in the railroad business. Some of the commodities in NS Rail's trafficmix, particularly those classified as hazardous materials, can pose specialrisks that NS Rail and its subsidiaries work diligently to minimize. In addition, several NS Rail subsidiariesown, or have owned, land used as operating property, or which is leased or mayhave been leased and operated by others, or held for sale. Because environmental problems that arelatent or undisclosed may exist on these properties, there can be no assurancethat NS will not incur environmental liabilities or costs with respect to oneor more of them, the amount and materiality of which cannot be estimatedreliably at this time. Moreover,lawsuits and claims involving these and potentially other unidentifiedenvironmental sites and matters are likely to arise from time to time. The resulting liabilities could have asignificant effect on financial condition, results of operations or liquidityin a particular year or quarter.

 

However,based on an assessment of known facts and circumstances, management believesthat it is unlikely that any known matters, either individually or in theaggregate, will have a material adverse effect on NS Rail's financial position,results of operations or liquidity.

 

18

 

**FORWARD-LOOKINGSTATEMENTS**

 

This Management's Discussion and Analysis of FinancialCondition and Results of Operations contains forward-looking statements thatmay be identified by the use of words like "believe,""expect," "anticipate" and "project." Forward-looking statements reflectmanagement's good-faith evaluation of information currently available. However, such statements are dependent onand, therefore, can be influenced by, a number of external variables over whichmanagement has little or no control, including: domestic and internationaleconomic conditions; the business environment in industries that produce andconsume rail freight; competition and consolidation within the transportationindustry; fluctuation in prices of key materials, in particular diesel fuel;labor difficulties, including strikes and work stoppages; legislative andregulatory developments; changes in securities and capital markets; and naturalevents such as severe weather, floods and earthquakes. Forward-looking statements are not, andshould not be relied upon as, a guaranty of future performance or results. Nor will they necessarily prove to beaccurate indications of the times at or by which any such performance orresults will be achieved. As a result, actual outcomes and results may differmaterially from those expressed in forward-looking statements. The Company undertakes no obligation toupdate or revise forward-looking statements.

 

 

**Item 3. Quantitativeand Qualitative Disclosures About Market Risks.**

 

Theinformation required by this item is included in Part I, Item 2,"Management's Discussion and Analysis of Financial Conditions and Resultsof Operations" on page 17 under the heading "Market Risks and HedgingActivities."

 

 

**Item 4. Controls and Procedures.******

 

(a) Evaluation ofDisclosure Controls and Procedures.

 

NS Rail's ChiefExecutive Officer and Chief Financial Officer have evaluated the effectivenessof NS Rail's disclosure controls and procedures (as such term is defined inRules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, asamended (the "Exchange Act")) as of the end of the period covered bythis report. Based on such evaluation,such officers have concluded that, as of the end of the period covered by thisreport, NS Rail's disclosure controls and procedures are effective in alertingthem on a timely basis to material information relating to NS Rail (includingits consolidated subsidiaries) required to be included in NS Rail's periodicfilings under the Exchange Act.

 

(b) Changes inInternal Controls.

 

During the most recentfiscal quarter, there has not been any change in NS Rail's internal controlover financial reporting that has materially affected, or is reasonably likelyto materially affect, NS Rail's internal control over financial reporting.

 

19**PART II. OTHER INFORMATION**

 

 

**Item6. Exhibits and Reports on Form 8-K**

 

 

(a)  Exhibits:

 

31     Certificationsof the CEO and CFO pursuant to Exchange Act Rule 13a-14(a) or Rule 15d-14(a).

 

32     Certificationsof the CEO and CFO required by Rule 13a-14(b) or Rule 15d-14(b) and Section1350 of Chapter 63 of Title 18 of the U. S. Code.

 

 (b)  Reports on Form 8-K:

 

         None.

 

20

 

**SIGNATURES**

 

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|   |           | NORFOLK  SOUTHERN RAILWAY COMPANY |
|--------|----------------|-----------------------------------|
|   |           | Registrant                        |
|   |           |                              |
|   |           |                              |
|   |           |                              |
|   |           |                              |
|   |           |                              |
|   |           |                              |
| Date:  | July  30, 2003 | /s/  Reginald J. Chaney           |  
 

 

Reginald  J. Chaney

 

 

Corporate  Secretary (Signature)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Date:

July  30, 2003

/s/  John P. Rathbone

 
 

 

John  P. Rathbone

 

 

Vice  President and Controller

 

 

(Principal  Accounting Officer) (Signature)

 

21

 
****
**Exhibit Index******

 

 

** **
Electronic
 ****

 ****

**Submission**

 ****

 ****

**Exhibit**

 ****

 ****

**Number**

**Description******

 ****

 ****

 ****

 ****

31

Certifications of  the CEO and CFO pursuant to Exchange Act Rule 13a-14(a)

 

 

or  Rule 15d-14(a).

 

 

 

 

32

Certifications of  the CEO and CFO required by Rule 13a-14(b) or Rule 15d-14(b)

 

 ****

and  Section 1350 of Chapter 63 of Title 18 of the U. S. Code.

 ****

 ****

 

 ****

 

22 |