| 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 **SEPT. 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 Sept. 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 Nine Months Ended Sept. 30, 2003 and 2002 |
|           |                    |                                                 |   |
|           |                    | Consolidated  Balance Sheets                         | 4      |
|           |                    | Sept.  30, 2003 and Dec. 31, 2002                    |   |
|           |                    |                                                 |   |
|           |                    | Consolidated  Statements of Cash Flows               | 5      |
|           |                    | Nine  Months Ended Sept. 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  1.                | Legal  Proceedings                                   | 20     |
|           |                    |                                                 |   |
|           | Item  6.                | Exhibits  and Reports on Form 8-K                    | 20     |
|           |                    |                                                 |   |
| Signatures     |                    | 21                                                   |
|           |                    |                                                 |   |
| Exhibit  Index |                    | 22                                                   |
|                |                         |                                                      |        |  |  |

 

 

2PART 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** | **Nine Months  Ended** |
|---------------------------------------------------------------------------------------------|-------------------------|------------------------|
|                                                                                        | **Sept. 30,**           | **Sept. 30,**          |
|                                                                                        | **2003**                | **2002**               | **2003** | **2002** |
|                                                                                        |                    |                   |   |   |   |   |   |   |
| ***Railway  operating revenues:***                                                          |                    |                   |   |   |   |   |   |   |
|    Coal                                                                      | $                       | 372               | $ | 371  | $ | 1,115  | $ | 1,080  |
|    General  merchandise                                                      |                    | 911               |   | 917  |   | 2,773  |   | 2,734  |
|    Intermodal                                                                |                    | 270               |   | 268  |   | 773  |   | 746  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
|       Total  Railway Operating Revenues                       |                    | 1,553             |   | 1,556  |   | 4,661  |   | 4,560  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
| ***Railway  operating expenses:***                                                          |                    |                   |   |   |   |   |   |   |
|    Compensation  and benefits                                                |                    | 396               |   | 390  |   | 1,197  |   | 1,150  |
|    Materials,  services and rents                                            |                    | 449               |   | 465  |   |  1,395  |   |  1,372  |
|    Conrail  rents and services (Note 2)                                      |                    | 119               |   | 112  |   |  356  |   |  348  |
|    Depreciation                                                              |                    | 124               |   | 125  |   | 370  |   | 373  |
|    Diesel  fuel                                                              |                    | 86                |   | 81  |   | 283  |   | 246  |
|    Casualties  and other claims                                              |                    | 44                |   | 57  |   | 143  |   | 129  |
|    Other                                                                     |                    | 68                |   | 67  |   | 215  |   | 206  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
|       Total  Railway Operating Expenses                       |                    | 1,286             |   | 1,297  |   | 3,959  |   | 3,824  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
|          Income  from railway operations       |                    | 267               |   | 259  |   | 702  |   | 736  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
| Other  income (expense) - net                                                          |                    | (60)                   |   | (44) |   | (176) |   | (156) |
| Interest  expense on debt                                                                   |                    | (6)                    |   | (6) |   | (18) |   | (22) |
|                                                                                        |                    |                   |   |   |   |   |   |   |
|          Income  before income taxes and       |                    |                   |   |   |   |   |   |   |
|             accounting  changes |                    | 201               |   | 209  |   | 508  |   | 558  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
| Provision  for income taxes                                                                 |                    | 74                |   | 85  |   | 193  |   | 223  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
|          Income  before accounting changes     |                    | 127               |   | 124  |   | 315  |   | 335  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
| Cumulative  effect of changes in accounting                                                 |                    |                   |   |   |   |   |   |   |
|    principles,  net of taxes (Note 1)                                        |                    | --                |   | --  |   | 104  |   | --   |
|                                                                                        |                    |                   |   |   |   |   |   |   |
|       Net  Income                                             | $                       | 127               | $ | 124  | $ | 419  | $ | 335  |
|                                                                                        |                    |                   |   |   |   |   |   |   |
|                                                                                        |                    |                   |   |   |   |   |   |   |
| *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)**

** **

 

|                                                                            | **Sept. 30,** | **Dec. 31,** |
|---------------------------------------------------------------------------------|---------------|--------------|
|                                                                            | **2003**      | **2002**     |
| ***Assets***                                                                    |          |         |   |   |
| Current assets:                                                                 |          |         |   |   |
|    Cash and cash equivalents                                     | $             | 129     | $ | 130  |
|    Accounts receivable, net  (Note 2)                            |          | 123     |   | 117  |
|    Due from Conrail (Note 2)                                     |          | 6       |   | 6  |
|    Materials and supplies                                        |          | 91      |   | 95  |
|    Deferred income taxes                                         |          | 184     |   | 174  |
|    Other current assets                                          |          | 46      |   | 131  |
|       Total  current assets                       |          | 579     |   | 653  |
|                                                                            |          |         |   |   |
| Investments (Note 4)                                                            |          | 753     |   | 703  |
| Properties less accumulated depreciation                                        |          | 11,167  |   | 10,837  |
| Other assets                                                                    |          | 693     |   | 660  |
| **      **Total  assets                           | $             | 13,192  | $ | 12,853  |
|                                                                            |          |         |   |   |
| ***Liabilities and Stockholders' Equity***                                      |          |         |   |   |
| Current liabilities:                                                            |          |         |   |   |
|    Accounts payable                                              | $             | 884     | $ | 860  |
|    Income and other taxes                                        |          | 202     |   | 187  |
|    Due to NS - net (Note 2)                                      |          | 430     |   | 384  |
|    Due to Conrail (Note 2)                                       |          | 65      |   | 86  |
|    Other current liabilities                                     |          | 114     |   | 122  |
|    Current maturities of  long-term debt                         |          | 102     |   | 94  |
|       Total  current liabilities                  |          | 1,797   |   | 1,733  |
|                                                                            |          |         |   |   |
| Long-term debt                                                                  |          | 830     |   | 763  |
| Other liabilities                                                               |          | 991     |   | 971  |
| Due to Conrail (Note 2)                                                         |          | 688     |   | 513  |
| Minority interests                                                              |          | 8       |   | 3  |
| Deferred income taxes                                                           |          | 4,271   |   | 4,057  |
|       Total  liabilities                          |          | 8,585   |   | 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)              |          | 243     |   | 266  |
|    Retained income                                               |          | 3,433   |   | 3,616  |
|       Total  stockholders' equity                 |          | 4,607   |   | 4,813  |
|                                                                            |          |         |   |   |
|       Total  liabilities and stockholders' equity | $             | 13,192  | $ | 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)**

** **

 

|                                                                                                                                 | Nine Months  Ended |
|--------------------------------------------------------------------------------------------------------------------------------------|--------------------|
|                                                                                                                                 | **Sept.  30,**     |
|                                                                                                                                 | **2003**           | **2002** |
| ***Cash  flows from operating activities***                                                                                          |               |   |   |   |
|    Net  income                                                                                                        | $                  | 419  | $ | 335  |
|    Reconciliation  of net income to net cash                                                                          |               |   |   |   |
|       provided  by operating activities:                                                               |               |   |   |   |
|          Net  cumulative effect of changes in accounting principles                     |               | (104) |   | --  |
|          Depreciation                                                                   |               | 371  |   | 374  |
|          Deferred  income taxes                                                         |               | 115  |   | 142  |
|          Gains  and losses on properties and investments                                |               | (9) |   | (15) |
|          Changes  in assets and liabilities affecting operations:                       |               |   |   |   |
|             Accounts  receivable                                         |               | (6) |   | 26  |
|             Materials  and supplies                                      |               | 4  |   | (1) |
|             Other  current assets and due from Conrail                   |               | 77  |   | 72  |
|             Income  tax liabilities                                      |               | 68  |   | 46  |
|             Other  short-term liabilities                                |               | (9) |   | (31) |
|             Other  - net                                                 |               | (26) |   | (78) |
|                Net  cash provided by operating activities |               | 900  |   | 870  |
|                                                                                                                                 |               |   |   |   |
| ***Cash  flows from investing activities***                                                                                          |               |   |   |   |
|    Property  additions                                                                                                |               | (392) |   | (501) |
|    Property  sales and other transactions                                                                             |               | 34  |   | 7  |
|    Investments,  including short-term                                                                                 |               | (80) |   | (54) |
|    Investment  sales and other transactions                                                                           |               | 3  |   | --  |
|                Net  cash used for investing activities    |               | (435) |   | (548) |
|                                                                                                                                 |               |   |   |   |
| ***Cash  flows from financing activities***                                                                                          |               |   |   |   |
|    Dividends                                                                                                          |               | (2) |   | (2) |
|    Advances  to NS                                                                                                    |               | (586) |   | (556) |
|    Advances  and repayments from NS                                                                                   |               | 31  |   | 6  |
|    Proceeds  from borrowings                                                                                          |               | 218  |   | 281  |
|    Debt  repayments                                                                                                   |               | (127) |   | (142) |
|                Net  cash used for financing activities    |               | (466) |   | (413) |
|                                                                                                                                 |               |   |   |   |
|                Net  decrease in cash and cash equivalents |               | (1) |   | (91) |
|                                                                                                                                 |               |   |   |   |
| ***Cash  and cash equivalents***                                                                                                     |               |   |   |   |
|    At  beginning of year                                                                                              |               | 130  |   | 167  |
|                                                                                                                                 |               |   |   |   |
|    At  end of period                                                                                                  | $                  | 129  | $ | 76  |
|  ******                                                                                                                         |               |   |
| ***Supplemental  disclosures of cash flow information***                                                                             |               |   |
|    Cash  paid during the period for:                                                                                  |               |   |   |   |
|       Interest  (net of amounts capitalized)                                                           | $                  |  29  | $ |  38  |
|       Income  taxes                                                                                    | $                  |  9  | $ |  29  |
|                                                                                                                                 |               |   |   |   |
| *See  accompanying notes to consolidated financial statements.*                                                                      |

 

5

 

**NORFOLK SOUTHERN RAILWAY COMPANY AND SUBSIDIARIES**

**(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 presentNorfolk Southern Railway Company and Subsidiaries' ("NS Rail") financialposition as of Sept. 30, 2003, its results of operations for the three and ninemonths ended Sept. 30, 2003 and 2002, and its cash flows for the nine monthsended Sept. 30, 2003 and 2002, in conformity with accounting principlesgenerally 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 NS Rail's latest Annual Report onForm 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 third quarter and $21million in the first nine months (because the depreciation rate for crosstiesno longer reflects cost to remove) and increased compensation and benefits andother expenses by about $6 million for the quarter and $16 million for thefirst nine 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 inaccounting on years prior to 2003. Pursuant to FIN No. 46, NS Rail has consolidated a special-purposeentity that leases certain locomotives to NS Rail. This entity's assets and liabilities at Jan. 1, 2003, included$169 million of locomotives and $157 million of debt related to their purchaseas well as a $6 million minority interest liability. This change in accounting increased depreciation and interestexpense (to reflect the locomotives as owned assets) and lowered leaseexpense. The net effect to totalrailway operating expenses 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 $140 million and $118 million in the third quarters of 2003 and2002, respectively (including a $8 million and $7 million mark-up in eachquarter, respectively) and $420 million and $392 million for the first ninemonths of 2003 and 2002, respectively (including an $26 million and $24 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 $23 million in each of the third quarters of 2003and 2002, and $69 million and $68 million for the first nine months of 2003 and2002, respectively.

 

NS Railowns 21,116,125 shares of NS common stock.

 

## 6

## 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 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 theOpera-ting Agreement are subject to adjustment every six years to reflectchanges in values. NSR also has leasedor subleased 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 ("STB")to establish 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 $350 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. Registration statementson Form S-4 will be filed with the U.S. Securities and Exchange Commission inconnection 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 this note comprise the long-term balance of"Due to Conrail." Theinterest rate

 

7

 

forthese loans is variable and was 1.51% at Sept. 30, 2003. On a consolidated basis, the proposedspin-off transaction described above would effectively relieve NS Rail of thisobligation. The current balance"Due to Conrail" is composed of amounts related to expenses includedin "Conrail rents and services," as discussed above.

 

NSRail's Consolidated Balance Sheet at Sept. 30, 2003, includes $38 million ofliabilities related to the Conrail transaction, principally for contractualobligations to Conrail employees imposed by the STB when it approved thetransaction. Through Sept. 30, 2003, NSRail has paid $145 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, $571 million at Sept. 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**

 

|                                      | **Sept.  30, 2003** | **Dec.  31, 2002** |
|-------------------------------------------|---------------------|--------------------|
|                                      |  ****          |  ****         | **Average** |  **** |  **** | Average |
|                                      |  ****          |  ****         | **Interest** |  **** |  **** | **Interest** |
|                                      | **Balance**         | **Rate**           | **Balance** | **Rate** |
|                                      | *($  in millions)*  |
|                                      |                |               |   |   |   |   |
|   Advances  due from NS         | $                   | 67            | 2% | $ | 68  | 2% |
|                                      |                |               |   |   |   |   |
|   Advances  and notes due to NS |                | (497)              | 2% |   | (452) | 2% |
|                                      |                |               |   |   |   |   |
|   Due  to NS - net              | $                   | (430)              |   | $ | (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 nine months ended Sept. 30 include interest income of $8 millionin 2003 and in 2002 and interest expense of $6 million in 2003 and $8 millionin 2002 related to these intercompany accounts. These amounts are included in "Other income (expense) -net."

 

**NoncashDividend**

 

NS Rail declared andissued to NS noncash dividends totaling $600 million in June and Sept. 2003,and $333 million in Sept. 2002, which were settled by reduction of NSRail's interest-bearing advances due from NS. Noncash dividends are excluded from the Consolidated Statements of CashFlows.

 

### 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 $979 million at Sept.30, 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

 

8

 

managementhas determined that its derivative financial instruments qualify as eitherfair-value or cash-flow hedges, having values which highly correlate with theunderlying hedged exposures, and has designated such instruments as hedgingtransactions. Credit risk related tothe derivative financial instruments is considered to be minimal and is managedby requiring high credit standards for counterparties and periodic settlements.

 

**DieselFuel Hedging**

 

In the second quarter of 2001, NS Rail began aprogram to hedge a portion of its diesel fuel consumption. The intent of the program is to assist inthe management of NS Rail's aggregate risk exposure to fuel price fluctuations,which can significantly affect NS Rail's operating margins andprofitability. In order to minimizethis risk, NS Rail instituted a continuous hedging strategy for a portion ofits estimated future fuel needs by entering into a series of swaps in order tolock 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:

 

|                                                                                                      |              | Third  quarter |
|-----------------------------------------------------------------------------------------------------------|-------------------|----------------|
|                                                                                                      |              | **2003**       | **2002** |
| Number of swaps entered into during the third  quarter                                                    |              | 72             | 72 |
| Approximate number of gallons hedged  (millions)                                                          |              | 95             | 97 |
| Approximate average price per gallon of Nymex                                                             |              |           |   |
|    No. 2 heating oil                                                                       |              |  $0.73    |  $0.69 |
|                                                                                                      |  ****        |           |   |
|                                                                                                      | **Remainder  of** |           |   |
|                                                                                                      | **2003**          | **2004**       | **2005** |
| Percent of estimated future diesel  fuel consumption

   covered as of Sept. 30, 2003 | 77%               | 52%            | 13% |
|                                                                                                           |                   |                |  |  |  |

 

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 monthlyforecasted fuel consumption will be hedged for any month within the 36-monthperiod. Diesel fuel costs represented 7% and 6% of NS Rail's operating expensesfor the third quarters of 2003 and 2002, respectively.

 

NS Rail's fuel hedgingactivity had the following effects on diesel fuel expense: for the third quarter, decreases of $11million and $5 million for 2003 and 2002, respectively, and for the first ninemonths, decreases of $45 million and $2 million for 2003 and 2002,respectively. The effect of the hedgeswas to yield average costs per gallon (including federal taxes andtransportation) of 77 cents and 73 cents for the third quarters of 2003 and2002, respectively, and 81 cents and 70 cents for the first nine 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 less than $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$194 million, or 34.5%, and $220 million, or 35.4%, of its fixed rate debtportfolio hedged at Sept. 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 Sept. 30, 2003,and Dec. 31, 2002, were determined based upon current fair market values asquoted by third party dealers. Fairvalues of interest rate

 

9

 

swapswere determined based upon the present value of expected future cash flowsdiscounted at the appropriate implied spot rate from the spot rate yieldcurve. Fair value adjustments arenon-cash transactions, and accordingly, are excluded from the ConsolidatedStatement of Cash Flows. "Accumulated other comprehensive loss," a component of"Stockholders' equity," included an unrealized pretax gain of $22million and an unrealized pretax loss of $1 million at Sept. 30, 2003, andan unrealized pretax gain of $29 million at Dec. 31, 2002, related to the fairvalue of derivative fuel hedging transactions that will terminate within twelvemonths of the respective dates.

 

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

 

|                                                | **Sept.  30,**     | **Dec.  31,** |
|-----------------------------------------------------|--------------------|---------------|
|                                                | **2003**           | **2002**      |
|                                                | *($  in millions)* |
| **Interest rate hedges:**                           |               |          |   |   |
|   Gross fair market asset position        | $                  | 19       | $ | 24  |
|   Gross fair market (liability)  position |               | --       |   | --  |
|                                                |               |          |   |   |
| **Fuel hedges:**                                    |               |          |   |   |
|   Gross fair market asset position        |               | 25       |   | 29  |
|   Gross fair market (liability)  position |               | (1)           |   | --  |
|                                                |               |          |   |   |
| Total net asset position                            | $                  | 43       | $ | 53  |

 

**4. Comprehensive Income**

 

 

NS Rail'stotal comprehensive income was as follows:

 

|                               | **Three  months Ended** | Nine months Ended |
|------------------------------------|-------------------------|-------------------|
|                               | **Sept.  30,**          | **Sept.  30,**    |
|                               | **2003**                | **2002**          | **2003** | **2002** |
|                               | *($  in millions)*      |
|                               |                    |              |   |   |   |   |   |   |
| Net  income                        | $                       | 127          | $ | 124  | $ | 419  | $ | 335 |
| Other  comprehensive income (loss) |                    | (16)              |   | (35) |   | (23) |   | 50 |
|                               |                    |              |   |   |   |   |   |   |
| Total  comprehensive income        | $                       | 111          | $ | 89  | $ | 396  | $ | 385 |

 

"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 income protection benefits where the aggregated range ofloss could be from zero to $9 million. A number of claims have been filed with NSR on behalf of employeesfurloughed after June 1, 1999, for various periods of time, alleging thatthe furloughs were a result of the Conrail transaction and seeking "New YorkDock" income protection benefits. Other disputes are pending wherein similar benefits are sought underlabor agreement provisions that, in management's judgment, do not apply to theinvolved circumstances. A number

 

10

 

ofclaims on behalf of individual employees have been submitted toarbitration. Three significant caseshave been heard and NSR received favorable decisions in each of them. Management believes that NSR will prevail inthese matters; however, an unfavorable outcome could result in accruals thatcould be significant to results of operations in a particular year or quarter.

 

**Casualty Claims**

 

NSRail is generally self-insured for casualty claims. NS Rail has insurance for catastrophic events, but that coveragehas upper limits. The casualty claimsliability is determined actuarially, based upon claims filed and an estimate ofclaims incurred but not yet reported. While the ultimate amount of claims incurred is dependent on futuredevelopments, in management's opinion, the recorded liability is adequate tocover the future payments of claims. However, it is possible that the recorded liability may not be adequateto cover the future payments of claims. Adjustments to the recorded liability are reflected in operatingexpenses in the periods in which such adjustments are known.

 

**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) on 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 $25 million at Sept. 30, 2003, and $29 million at Dec. 31, 2002(of which $8 million was accounted for as a current liability for eachperiod). At Sept. 30, 2003, theliability represented NS Rail's estimate of the probable cleanup andremediation costs based on available information at 113 known locations. On that date, 10 sites accounted for $13million 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 113 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 and LiabilityAct of 1980, or comparable state statutes, which often impose joint and severalliability 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 cleanup technologies,the difficulty of determining in advance the nature and full extent ofcontamination and each potential participant's share of any estimated loss (andthat participant's ability to bear it) and evolving statutory and regulatorystandards 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 NS Rail is aware. Further,

 

11

 

managementbelieves that it is unlikely that any identified matters, either individuallyor in the aggregate, will have a material adverse effect on NS Rail's financialposition, results of operations or liquidity.

 

**Purchase Commitments**

 

AtSept. 30, 2003, NS Rail had outstanding purchase commitments of approximately$14 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 the accompanying consolidatedbalance sheet of Norfolk Southern Railway Company and subsidiaries as ofSeptember 30, 2003, and the related consolidated statements of income for thethree-month and nine-month periods ended September 30, 2003 and 2002 and therelated consolidated statements of cash flows for the nine-month periods endedSeptember 30, 2003 and 2002. Theseconsolidated financial statements are the responsibility of the Company'smanagement.

 

We conducted our reviews in accordance withstandards established by the American Institute of Certified PublicAccountants. A review of interimfinancial information consists principally of applying analytical proceduresand making inquiries of persons responsible for financial and accountingmatters. It is substantially less inscope than an audit conducted in accordance with auditing standards generallyaccepted in the United States of America, the objective of which is the expressionof an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such anopinion.

 

Based on our reviews, we are not aware of anymaterial modifications that should be made to the consolidated financialstatements referred to above for them to be in conformity with accountingprinciples generally accepted in the United States of America. 

 

As discussed in Note 1 to the consolidatedfinancial statements, the Company adopted Financial Accounting Standards BoardStatement No. 143, *Accounting for Asset Retirement Obligations,* andFinancial Accounting Standards Board Interpretation No. 46, *Consolidation ofVariable Interest Entities,* as of January 1, 2003.

 

We have previously audited, in accordance withauditing standards generally accepted in the United States of America, theconsolidated balance sheet of Norfolk Southern Railway Company and subsidiariesas of December 31, 2002, and the related consolidated statements of income,changes in stockholders' equity and cash flows for the year then ended (notpresented herein); and in our report dated January 28, 2003, we expressed anunqualified opinion on those consolidated financial statements. In our opinion, the information set forth inthe accompanying consolidated balance sheet as of December 31, 2002, is fairlystated, in all material respects, in relation to the consolidated balance sheetfrom which it has been derived.

 

 

/s/ KPMG LLP

Norfolk, Virginia

October 28, 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

 

Third-quarter netincome was $127 million in 2003, up $3 million, or 2%, compared with the sameperiod last

year, benefiting fromhigher income from operations. For thefirst nine months of 2003, net income was $419 million and included $104million for the cumulative effect on years prior to 2003 of changes inaccounting principles as required by the adoption of two accountingpronouncements (see Note 1). Nine-month income before accounting changes was $315 million, down $20million, or 6%, compared with results for the same period of 2002. The decline was primarily the result oflower income from railway operations offset, in part, by a lower effective taxrate.

 

### Railway Operating Revenues

 

Third-quarter railway operatingrevenues were $1.6 billion in 2003, down $3 million, compared with the thirdquarter of last year. For the firstnine months, revenues were $4.7 billion, up $101 million, or 2%. As shown in the following table, the thirdquarter decrease was due to reduced traffic volume offset in part by higheraverage revenues, while the increase for the first nine months was the resultof increased average revenues and higher traffic volume.

 

|                                | Third  quarter                         | **First  nine months**                        |
|-------------------------------------|----------------------------------------|-----------------------------------------------|
|                                | **2003  vs. 2002**                     | **2003  vs. 2002**                            |
|                                | **Increase  (Decrease)**               | **Increase  (Decrease)**                      |
|                                | *($ in millions)*                      |
|                                |                                   |                                          |
| Traffic volume (carloads)           | $   (13)                | $    42                   |
| Revenue per unit/mix                |       10 |        59  |
|      Total | $       (3)        | $   101                        |

 

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):

 

|                                         | **Third  Quarter** |
|----------------------------------------------|--------------------|
|                                         | **Revenue**        | **Carloads** | **Revenue  per Unit** |
|                                         | **2003**           | **2002** | **2003** | **2002** | **2003** | **2002** |
|                                         | *($  in millions)* | *(in  thousands)* | *($  per unit)* |
|                                         |               |   |   |   |   |   |   |   |   |   |   |   |
| Coal                                         | $                  | 372 | $ | 371 |   | 407 |   | 413 | $ | 915 | $ | 900 |
| General merchandise:                         |               |   |   |   |   |   |   |   |   |   |   |   |
|    Automotive                 |               | 205 |   | 231 |   | 142 |   | 155 |   | 1,447 |   | 1,494 |
|    Chemicals                  |               | 196 |   | 194 |   | 108 |   | 110 |   | 1,805 |   | 1,768 |
|    Metals/construction        |               | 180 |   | 181 |   | 187 |   | 193 |   | 965 |   | 935 |
|    Agr./consumer  prod./govt. |               | 167 |   | 156 |   | 138 |   | 127 |   | 1,212 |   | 1,219 |
|    Paper/clay/forest          |               | 163 |   | 155 |   | 113 |   | 113 |   | 1,445 |   | 1,379 |
|                                         |               |   |   |   |   |   |   |   |   |   |   |   |
| General  merchandise                         |               | 911 |   | 917 |   | 688 |   | 698 |   | 1,325 |   | 1,313 |
| Intermodal                                   |               | 270 |   | 268 |   | 627 |   | 625 |   | 430 |   | 429 |
|                                         |               |   |   |   |   |   |   |   |   |   |   |   |
|       Total    | $                  | 1,553 | $ | 1,556 |   | 1,722 |   | 1,736 | $ | 902 | $ | 896 |

13

 

|                                         | **First  Nine Months** |
|----------------------------------------------|------------------------|
|                                         | Revenues               | **Carloads** | **Revenue  per Unit** |
|                                         | **2003**               | **2002** | **2003** | **2002** | **2003** | **2002** |
|                                         | *($  in millions)*     | *(in  thousands)* | *($  per unit)* |
|                                         |                   |   |   |   |   |   |   |   |   |   |   |   |
| Coal                                         | $                      | 1,115 | $ | 1,080 |   | 1,222 |   | 1,204 | $ | 913 | $ | 897 |
| General  merchandise:                        |                   |   |   |   |   |   |   |   |   |   |   |   |
|    Automotive                 |                   | 689 |   | 718 |   | 477 |   | 499 |   | 1,444 |   | 1,439 |
|    Chemicals                  |                   | 578 |   | 567 |   | 319 |   | 319 |   | 1,812 |   | 1,779 |
|    Metals/construction        |                   | 521 |   | 530 |   | 532 |   | 551 |   | 980 |   | 962 |
|    Agr./consumer  prod./govt. |                   | 510 |   | 469 |   | 409 |   | 382 |   | 1,245 |   | 1,227 |
|    Paper/clay/forest          |                   | 475 |   | 450 |   | 333 |   | 330 |   | 1,428 |   | 1,365 |
|                                         |                   |   |   |   |   |   |   |   |   |   |   |   |
| General  merchandise                         |                   | 2,773 |   | 2,734 |   | 2,070 |   | 2,081 |   | 1,340 |   | 1,314 |
| Intermodal                                   |                   | 773 |   | 746 |   | 1,814 |   | 1,774 |   | 426 |   | 421 |
|                                         |                   |   |   |   |   |   |   |   |   |   |   |   |
|       Total    | $                      | 4,661 | $ | 4,560 |   | 5,106 |   | 5,059 | $ | 913 | $ | 901 |

 

**Coal**

 

Coal revenuesincreased $1 million in the third quarter and $35 million, or 3%, in thefirst nine months, compared with the same periods last year. Total traffic volume (tonnage) handleddecreased 1% in the quarter, but increased 2% for the first nine months,primarily because of higher utility and export coal volume. Shipments of export coal increased 40% inthe quarter and 12% for the first nine months, due to blend changes, the impactof ocean rates and the value of the dollar. Industrial coal volume increased 8% in the quarter, as low inventoriesat plants began to be replenished, but decreased 6% for the first ninemonths. Average revenue per carload wasup 2% in the third quarter and first nine months, reflecting a favorable changein the mix of traffic (increased export volume).

 

For the remainder of the year, coal volumes areexpected to continue to be higher, although mild weather patterns could dampenthis outlook. Utility stockpiles areestimated to be below normal and utilities should begin rebuilding stockpilesin anticipation of winter, and gas prices remain relatively high, which couldlead to greater utilization of coal-fired generation plants.

 

As disclosed in NS Rail's 2002 10-K, since early2002, two utility customers have rate reasonableness complaints before theSTB. Until resolved, NS Rail is billingand collecting amounts from these customers based on the challenged tariffrates. NS Rail currently expects theSTB 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 $6 million, or 1%, in the third quarter, butincreased $39 million, or 1%, in the first nine months, compared with thesame periods last year. The decline forthe quarter was the result of lower traffic volume (carloads), which waspartially offset by higher average revenues. For the first nine months, the revenue increase reflected higher averagerevenues. For both periods, the largestvolume decreases were in the automotive and metals and constructiongroups. Automotive traffic volumereflected plant downtime at Ford and DaimlerChrysler. Metals and construction volume suffered from continued softnessin the imported steel market. Agriculture, consumer products and government volume increased 8% in thequarter and 7% for the first nine months reflecting increased volume forfertilizer, higher military shipments and more shipments of corn into marketsaffected by the 2002 drought. Paper,clay and forest products volume increased slightly for the quarter and was up1% for the first nine months.

 

General merchandise average revenue per carloadincreased 1% in the third quarter and 2% for the first nine months reflectingfuel surcharges, increased rates and longer lengths of haul.

 

14

 

While improvements are expectedin out metals and construction, chemicals and agriculture business groups,overall, general merchandise revenues are expected to show weakness during thelast quarter of the year and are largely dependent upon the performance of theeconomy.

 

### Intermodal

 

Intermodalrevenues increased $2 million, or 1%, in the third quarter and$27 million, or 4%, in the first nine months, compared with the sameperiods last year. Traffic volume(units) was slightly higher in the third quarter and increased 2% for the firstnine months, which reflected higher trailer and Triple Crown trafficvolume. Container traffic volumebenefited from increased international and domestic truckload business as wellas the conversion of truck traffic to rail. Intermodal revenue per unit was just about even for the quarter, but up1% for the first nine months, as the favorable effects of fuel surcharges andancillary revenues offset an unfavorable change in the mix of traffic.

 

Intermodal revenuesare expected to show growth due to favorable year-over-year comparison from the2002 West Coast port shutdown, market share gains and new products, in additionto a steady recovery in the economy and continued high levels of consumerspending.****

 

### Railway Operating Expenses

 

Third-quarter railway operating expenses were$1.3 billion in 2003, down $11 million, or 1%, compared with last year. For the first nine months, expenses were$4.0 billion, up $135 million, or 4%.

 

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 $6million, or 2%, in the third quarter and $47 million, or 4%, in the firstnine months, compared with the same periods last year. Both comparisons reflected lower pensionincome, higher wage rates, increased medical costs (despite additional employeecontributions), expenses attributable to employee turnover (primarily anincrease in train and engine trainees).

 

In the thirdquarter, NS announced a voluntary separation program for nonagreement employeeswith at least two years of service. Theprogram offers severance pay of three weeks' salary for each year of service upto a maximum of 100 weeks, continued health care for one year at no cost andoutplacement services for up to 90 days. Voluntary separations will be effective on or before Nov. 30, 2003. The cost of this program, approximately $100million, will be reflected in fourth quarter results and consists of a cash andnon-cash component. The cash componentis estimated at approximately $65 million for severance benefits and thebalance will be a non-cash charge for postretirement medical and pensionbenefits.

 

Materials,services and rents decreased $16 million, or 3%, in the third quarter butincreased $23 million, or 2%, in the first nine months, compared with thesame periods last year. Both periodsreflected higher expenses for the management fee charged by NS (see Note 2);however, for the quarter, this was more than offset by lower automotive trafficvolume in addition to adjustments relating to periodic studies and favorablesettlements of recent bills.

 

Conrail rents and services expenses increased $7million, or 6%, in the third quarter and $8 million, or 2%, in the firstnine months, compared with the same periods last year. The increases were principally the result ofhigher Operating Agreement fees and higher expenses in the Shared Assets Areas.

 

Depreciation expense was down slightly in boththe third quarter and the first nine 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 $5 million, or6%, in the third quarter and $37 million, or 15%, in the first ninemonths, compared with the same periods last year, reflecting higher averageprices. The hedging program produced

 

15

 

benefits of $11 million and$45 million in the third quarter and first nine months of 2003,respectively, compared with a $5 million and a $2 million benefit forthe same periods of 2002.

 

Casualties and other claims expense decreased$13 million, or 23%, in the third quarter, but increased $14 million,or 11%, in the first nine months, compared with the same periods lastyear. The decrease for the quarterreflected lower unfavorable periodic study adjustments as compared with the prioryear. The increase for the first nine monthswas largely the result of continuing adverse personal injury claims developmentand higher insurance premiums, mitigated by an insurance recovery related to aprevious settlement. The increase forthe first nine months also reflected damage costs incurred because of severalderailments early in the year.

 

Other expenseincreased $1 million, or 1%, in the third quarter and $9 million, or 4%,in the first nine months, compared with the same periods of last year. Both periods reflected the absence of prioryear settlements - sales and use tax for the quarter and a favorable bad debtsettlement for the first nine months.

 

** **

**FINANCIAL CONDITION AND LIQUIDITY**

 

Cash provided byoperating activities, NS Rail's principal source of liquidity, was $900 millionin the first nine months of 2003, compared with $870 million in the first ninemonths of 2002.

 

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 theseborrowings amounted to $174 million in the first nine months of 2003 and $162million for the same period of 2002.

 

NS Rail's workingcapital deficit was $1.2 billion at Sept. 30, 2003, and $1.1 billion 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 $433 million, and the amount of receivablesNS sold ranged from zero to $120 million. Moreover, NS has a $1 billion credit facility, which expires in 2006,that it can borrow under or use to support commercial paper debt; however,reductions in its credit rating could limit NS' ability to access thecommercial paper markets.

 

As the major NSsubsidiary, NS Rail provides funding to service NS' debt. NS' debt at Sept. 30, 2003, totaled$6.2 billion. Of this debt, $1.8billion is due between 2003 and 2007.

 

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

 

Cash used forinvesting activities decreased in the first nine months of 2003, compared withthe first nine months of 2002, principally because of a decline in capitalexpenditures. The decrease reflectedthe absence of locomotive purchases in 2003.

 

Cash used forfinancing activities was $466 million in the first nine months of 2003,compared with $413 million in the same period of 2002, reflecting the absencein 2003 of proceeds from equipment financing. Advances to NS typically account for most of the cash used for financingactivities and reflect NS' requirements.

** **

** **

**OTHER MATTERS**

** **

**LaborArbitration**

 

Anumber of claims have been filed with NSR on behalf of employees furloughedafter June 1, 1999, for various periods of time, alleging that thefurloughs were a result of the Conrail transaction and seeking "New YorkDock"

 

16

 

incomeprotection benefits. Other disputes arepending wherein similar benefits are sought under labor agreement provisionsthat, in management's judgment, do not apply to the involvedcircumstances. A number of claims onbehalf of individual employees have been submitted to arbitration. Three significant cases have been heard andNSR received favorable decisions in each of them. In addition, a number of other claims have been settled orwithdrawn.

 

Basedon known facts, including the availability of legal defenses, managementbelieves NS Rail will prevail in these disputes and that any potentialliability for the involved claims should not have material adverse effect onNS Rail's financial position, results of operations or liquidity. Depending on the outcome of thesearbitrations and claims, other claims may be filed or progressed toarbitration. Should all such claimantsprevail, there could be a significant effect on results of operations in aparticular quarter (see Note 5).

 

**LaborAgreements**

 

Approximately24,000 of NS Rail's employees are covered by collective bargaining agreementswith 14 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; the International Brotherhoodof Electrical Workers (IBEW), which represents about 900 NS Rail employees; theAmerican Train Dispatchers Department (ATDD), which represents about 400 NSRail employees; and the Brotherhood of Railway Signalmen (BRS), whichrepresents about 1,100 NS Rail employees. The agreement previously reached with the BLE was through 2004; NS Railrecently reached a further contract extension with the BLE through 2009(subject to ratification). Health andwelfare issues have been resolved with the BMWE, TCU and BRS. Tentative agreements (subject toratification) have been reached with BLE, UTU and IBEW that would resolvehealth and welfare issues. Health andwelfare issues with the other organizations 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 third 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 Sept. 30, 2003, through swap transactions, NSRail has hedged approximately 77% of expected diesel fuel requirements for theremainder of 2003, and 52% and 13% of expected requirements for 2004 and 2005,respectively. The effect of the hedgesis to yield an average cost of 79 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 $31 million as of Sept. 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 Sept. 30, 2003, NSRail's debt subject to interest rate exposure totaled $546 million. A 1 percentage point increase in interestrates would increase NS Rail's total annual interest expense related to all itsvariable debt by

 

17

 

approximately $5million. Management considers itunlikely that interest rate fluctuations applicable to these instruments willresult in a material adverse effect on NS Rail's financial position, results ofoperations 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 Sept. 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 $3 million and $2 million for the third quarters of2003 and 2002, respectively, and by $7 million for both the first nine monthsof 2003 and 2002, respectively. Aportion of the lease obligations is payable in Japanese yen. NS Rail eliminated the associated exchangerate risk at the inception of each lease with a yen deposit sufficient to fundthe yen-denominated obligation. Most ofthese deposits are held by foreign banks, primarily Japanese. As a result, NS Rail is exposed to financialmarket risk relative to Japan. Counterparties to the interest rate swaps and Japanese banks holding yendeposits are major financial institutions believed by management to becreditworthy.

 

**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 $6 million for thefirst nine months of 2003 and $12 million for the same period of 2002. Capital expenditures totaled approximately$3 million and $5 million for the first nine months of 2003 and 2002,respectively.

 

NSRail's balance sheets included liabilities for environmental exposures in theamount of $25 million at Sept. 30, 2003, and $29 million at Dec. 31, 2002(of which $8 million was accounted for as a current liability in eachperiod). At Sept. 30, 2003, theliability represented NS Rail's estimate of the probable cleanup and remediationcosts based on available information at 113 known locations. On that date, 10 sites accounted for $13million 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 113 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 subsidiaries own,or have owned, land used as operating property, or which is leased or may havebeen leased and operated by others, or held for sale. Because environmental problems that are latent or undisclosed mayexist on these properties, there can be no assurance that NS will not incurenvironmental liabilities or costs with respect to one or more of them, theamount and materiality of which cannot be estimated reliably at this time. Moreover, lawsuits and claims involvingthese and potentially other unidentified environmental sites and matters arelikely to arise from time to time. Theresulting liabilities could have a significant effect on financial condition,results of operations or liquidity in a particular year or quarter.

 

18

 

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.

 

** **

**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 international economicconditions; the business environment in industries that produce and consumerail freight; competition and consolidation within the transportation industry;fluctuation in prices of key materials, in particular diesel fuel; labordifficulties, including strikes and work stoppages; legislative and regulatorydevelopments; changes in securities and capital markets; and natural eventssuch as severe weather, floods and earthquakes. Forward-looking statements are not, and should not be relied uponas, a guaranty of future performance or results. Nor will they necessarily prove to be accurate indications of thetimes at or by which any such performance or results will be achieved. As aresult, actual outcomes and results may differ materially from those expressedin forward-looking statements. TheCompany undertakes no obligation to update or revise forward-lookingstatements.

 

 

**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, as amended(the "Exchange Act")) as of the end of the period covered by thisreport. Based on such evaluation, suchofficers 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

 

**PARTII. OTHER INFORMATION**

 

 

**Item 1. Legal Proceedings**

** **

Norfolk Southern Railway Company, Conrail andPRR have entered into a consent order and agreement with the Commonwealth ofPennsylvania Department of Environmental Protection agreeing to pay a lump-sumcivil penalty of $550,000 in settlement of the state's claims for allegedenvironmental violations at Conway Yard, located in western Pennsylvania. In addition, the parties agreed tostipulated civil penalties of $1,000 per month for the first two years and$1,500 per month thereafter until certain conditions at the Yard areremediated.

 

**Item 6. 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:  | Oct.  30, 2003 | /s/  Reginald J. Chaney           |  
 

 

Reginald  J. Chaney

 

 

Corporate  Secretary (Signature)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Date:

Oct.  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 |