Item 1.
Business
COMPANY OVERVIEW
Kansas City Southern de México, S.A. de C.V. (“KCSM” or the “Company”) operates the primary commercial corridor of the Mexican railroad system, which allows it to participate significantly in the growing freight traffic between Mexico, the U.S. and Canada. KCSM’s rail lines consist of approximately 3,200 route miles. In addition, KCSM has trackage rights permitting it to run its trains over 700 miles of track of other Mexican railroad operators. KCSM provides freight transportation services under a 50-year concession granted to it by the Mexican government (the “Concession”), during the first 30 years of which the Company is the exclusive provider, subject to certain trackage rights of other freight carriers. KCSM’s Concession is renewable for an additional period of up to 50 years, subject to certain conditions.
The Company believes its rail lines comprise the most strategically significant and most actively traveled rail corridor in Mexico. The Company’s rail lines connect the most populated and industrialized regions of Mexico with the principal border gateway between Mexico and the U.S. at Nuevo Laredo, Tamaulipas and Laredo, Texas. In addition, KCSM serves three of Mexico’s most important seaports at Lazaro Cardenas, Michoacan on the Pacific Ocean and Tampico, Tamaulipas and Veracruz, Veracruz (through trackage rights granted by Ferrosur, S.A. de C.V. (“Ferrosur”), under its concession) on the Gulf of Mexico. As a result, the Company believes its routes are integral to Mexico’s foreign trade.
KCSM seeks to establish its railroad as the primary inland freight transporter linking Mexico with the U.S. and Canadian markets. As the operator of the primary and most direct rail corridor from Mexico City to the U.S. border, its route structure enables KCSM to benefit from continuing growth resulting from the North American Free Trade Agreement (“NAFTA”). KCSM is the only Mexican railroad that serves the Mexico-U.S. border crossing at Nuevo Laredo, Tamaulipas, the largest rail freight interchange point between Mexico and the U.S. Through the U.S. rail subsidiaries of Kansas City Southern (“KCS”), KCSM’s ultimate parent, as well as through interchanges with other major U.S. railroads, KCSM provides customers with access to an extensive network through which they may distribute products throughout North America and overseas.
The Company provides exclusive rail access to the Port of Lazaro Cardenas on the Pacific Ocean. The Mexican government is developing the port at Lazaro Cardenas principally to serve Mexican markets and as an alternative to the U.S. west coast ports. KCSM is the sole provider of rail service to this port, which provides an alternate route for Asian and South American traffic bound for North America.
KCSM’s revenues are derived from the movement of a diversified mix of commodities and products. The Company transports chemical and petroleum products, industrial and consumer products, agriculture and mineral products, intermodal and automotive products, and energy products. KCSM’s customers include leading international and Mexican corporations.
Kansas City Southern
KCSM is a wholly-owned subsidiary of KCS. KCS’s principal U.S. subsidiary, The Kansas City Southern Railway Company (“KCSR”), is a U.S. Class I railroad. The rail networks of KCSR; The Texas Mexican Railway Company (“Tex-Mex”), also a KCS wholly-owned subsidiary; and KCSM together comprise approximately 6,300 route miles extending from the midwest and southeast portions of the United States into Mexico.
RAIL SECURITY
KCS and its rail subsidiaries have made ongoing, multi-disciplinary efforts since the terrorist attacks on the United States on September 11, 2001, to continue securing KCS’s assets and personnel against the risk of terrorism and other security risks. Many of the specific measures KCS utilizes for these efforts are required to be kept confidential through arrangements with government agencies, such as the Department of Homeland Security (“DHS”), or through jointly-developed and implemented strategies and plans with connecting carriers. To protect the confidentiality and sensitivity of the efforts the Company has made to safeguard against terrorism and other security incidents, the following paragraphs will provide only a general overview of some of these efforts. KCSM utilizes a security plan based on an industry wide security plan developed by Association of American Railroads (“AAR”) members which focuses on comprehensive risk assessments in five areas - hazardous materials; train operations; critical physical assets; military traffic; and information technology and communications. The security plan is kept confidential, with access to the plan tightly limited to members of management with direct security and anti-terrorism implementation responsibilities. KCSM participates with other AAR members in periodic drills under the industry plan to test and refine its various provisions.
KCS’s security activities range from periodically mailing each employee a security awareness brochure (which is also posted under the “Employees” tab on KCS’s internet website, www.kcsouthern.com) to its ongoing implementation of security plans for rail facilities in areas labeled by the DHS as High Threat Urban Areas (“HTUAs”). KCS’s other activities to bolster security against terrorism include, but are not limited to, the following:
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Conferring regularly with other railroads’ security personnel and with industry experts on security issues;
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Routing shipments of certain chemicals, which might be toxic if inhaled, pursuant to applicable rules and regulations;
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Initiating a series of over 20 voluntary action items agreed to between AAR and DHS as enhancing security in the rail industry;
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Conducting constant and targeted security training as part of the scheduled training for operating employees and managers;
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Developing a multi-layered security model using high-speed digital imaging, system velocity, covert and overt security filters to mitigate the risk of illicit activity;
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Measuring key security metrics to ensure positive risk mitigation and product integrity trends;
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Implementation of a Tactical Intelligence Center by KCSM, training core members in new technology helping to prevent, detect, deter and respond to illicit activities; and
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Deployment of an array of non-intrusive technologies including, but not limited to, digital video surveillance and analytics as part of an intelligent video security solution, including a Closed Circuit Television platform with geo-fencing for intrusion detection, to allow for remote viewing access to monitor ports of entry, intermodal and rail yards.
In addition, KCS utilizes dedicated security personnel with extensive law enforcement backgrounds to oversee the ongoing and increasingly complex security efforts. Some members of this security force are also members of the FBI’s Joint Terrorism Task Force, providing added value to the Company in developing and implementing anti-terrorism and other security initiatives.
While the risk of theft and vandalism is higher in Mexico, KCSM remains among the safest methods of transportation for freight shipments in Mexico. KCSM’s record in rail safety is due in large part to the implementation of a multi-layered, safety and security process throughout the KCSM network. In addition to having its own internal system, the process is connected to, and supported by a high level of federal, state and local law enforcement. A primary focus of this effort involves maintaining constant due diligence, active vigilance and train velocity, which reduces the likelihood for incidents to occur.
COLLECTIVE BARGAINING
KCSM Servicios, S.A. de C.V. (“KCSM Servicios”) is a wholly-owned subsidiary of KCS. KCSM Servicios’ union employees are covered by one labor agreement, which was signed on June 23, 1997, between KCSM and the Sindicato de Trabajadores Ferrocarrileros de la República Mexicana (“Mexican Railroad Union”), for a term of 50 years, for the purpose of regulating the relationship between the parties. As of December 31, 2012, approximately 80% of KCSM Servicios employees are covered by this labor agreement. The compensation terms under this labor agreement are subject to renegotiation on an annual basis, and all other benefits are subject to negotiation every two years. As a result of the labor agreement signed on April 19, 2012, compensation terms for the period from July 1, 2012, through June 30, 2013, were finalized. Additionally, this labor agreement enabled KCS to complete an organizational restructuring whereby employees of KCSM became employees of KCSM Servicios. KCSM Servicios provides employee services to KCSM, and KCSM pays KCSM Servicios market-based rates for these services. The union labor negotiation with the Mexican Railroad Union has not historically resulted in any strike, boycott or other disruption in KCSM's business operations.
AVAILABLE INFORMATION
KCS’s website (www.kcsouthern.com) provides at no cost KCSM’s Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K, and amendments to those reports, as soon as reasonably practicable after the electronic filing of these reports is made with the Securities and Exchange Commission. Written requests for copies of these reports may be made to the Corporate Secretary, P.O. Box 219335, Kansas City, Missouri 64121-9335 (or if by express delivery to 427 West 12th Street, Kansas City, Missouri 64105).
Item 1A.
Item 1A.
Risk Factors
KCSM’s flexibility to operate its business could be impacted by provisions in its debt obligations.
KCSM’s debt instruments contain covenants which restrict or prohibit certain actions (“negative covenants”), including, but not limited to, KCSM’s ability to incur debt, create or suffer to exist liens, make prepayments of particular debt, make certain investments, engage in transactions with stockholders and affiliates, sell certain assets, engage in mergers and consolidations or in sale-leaseback transactions. The KCSM revolving credit facility contains additional negative covenants, including, but not limited to, KCSM’s ability to freely deploy proceeds in excess of pre-defined thresholds from insurance settlements. The aforementioned negative covenant terminates upon conversion of KCSM’s revolving credit facility from secured to unsecured upon KCSM’s attainment of investment grade credit ratings from at least two of the three primary rating agencies. KCSM’s debt instruments also contain covenants requiring KCSM to, among other things, maintain specified financial ratios (“affirmative covenants”). Failure to comply with these negative and affirmative covenants could result in an event of default that, if not cured or waived, could restrict the Company’s access to liquidity and have a material adverse effect on the Company’s business or prospects. If the Company does not have enough cash to service its debt or fund other liquidity needs, KCSM may be required to take actions such as requesting a waiver from lenders, reducing or delaying capital expenditures, selling assets, restructuring or refinancing all or part of the existing debt, or seeking additional equity capital. KCSM cannot assure that any of these remedies can be effected on commercially reasonable terms or at all.
A downturn in the debt capital markets or a downgrade of the Company’s credit ratings may increase the cost of borrowing and make financing difficult to obtain.
Events in the financial markets may have an adverse impact on the debt capital markets and, as a result, credit may become more expensive and difficult to obtain. Lenders may impose more stringent restrictions on the terms of credit and there may be a general reduction in the amount of credit available in the markets in which KCSM conducts business. Also, the Company and its securities are rated by Standard & Poor’s Rating Services (“S&P”), Moody’s Investors Service (“Moody’s”) and Fitch Ratings (“Fitch”). These ratings impact the Company’s cost of funds and its access to the debt capital markets. The negative impact of tightening credit markets, adverse changes in the debt capital markets generally and/or a downgrade of the Company’s credit ratings may have a material adverse effect on KCSM’s consolidated financial statements resulting from, but not limited to, an inability to finance capital expansion on favorable terms, if at all, reduced liquidity as a result of limited alternatives to refinance short-term debt, increased financing costs and/or financial terms with increasingly restrictive covenants.
KCSM’s Concession is subject to revocation or termination in certain circumstances which would prevent KCSM from operating its railroad and would have a material adverse effect on the Company’s consolidated financial statements.
KCSM operates under the Concession granted by the Mexican government in June 1997, which is renewable for an additional period of up to 50 years, subject to certain conditions. The Concession gives KCSM exclusive rights to provide freight transportation services over its rail lines for the first 30 years of the 50-year Concession, subject to certain trackage and haulage rights granted to other concessionaires. The Secretaría de Comunicaciones y Transportes (Secretary of Communications or “SCT”), which is principally responsible for regulating railroad services in Mexico, has broad powers to monitor KCSM’s compliance with the Concession, and it can require KCSM to supply it with any technical, administrative and financial information it requests. Among other obligations, KCSM must comply with the investment commitments established in its business plan, which forms an integral part of the Concession, and must update the plan every five years. The SCT treats KCSM’s business plans confidentially. The SCT also monitors KCSM’s compliance with efficiency and safety standards established in the Concession. The SCT reviews, and may amend, these standards every five years.
The Mexican Railroad Services Law and regulations provide the Mexican government certain rights in its relationship with KCSM under the Concession, including the right to take over the management of KCSM and its railroad in certain extraordinary cases, such as imminent danger to national security. In the past, the Mexican government has used such power with respect to other privatized industries, including the telecommunications industry, to ensure continued service during labor disputes. In addition, under Article 47 of the Mexican Railroad Services Law and its regulations, the SCT, in consultation with the Comisión Federal de Competencia (Mexican Antitrust Commission or “COFECO”), reserves the right to set service rates if it determines that effective competition does not exist in the Mexican railroad industry. COFECO, however, has not published guidelines regarding the factors that constitute a lack of competition. It is, therefore, unclear under what particular circumstances COFECO would deem a lack of competition to exist. If the SCT intervenes and sets service rates, the rates it sets may be too low to allow KCSM to operate profitably.
Under the Concession, KCSM has the right to operate its rail lines, but it does not own the land, roadway or associated structures. If the Mexican government legally terminates the Concession, it would own, control and manage such public domain assets used in the operation of KCSM’s rail lines. All other property not covered by the Concession, including all locomotives and railcars otherwise acquired, would remain KCSM’s property. In the event of early termination, or total or partial revocation of the Concession, the Mexican government would have the right to cause the Company to lease all service-related assets to it for a term of at least one year, automatically renewable for additional one-year terms up to five years. The amount of the rent would be determined by experts appointed by KCSM and the Mexican government. The Mexican government must exercise this right within four months after early termination or revocation of the Concession. In addition, the Mexican government would also have a right of first refusal with respect to certain transfers by KCSM of railroad equipment within 90 days after revocation of the Concession.
The Mexican government may also temporarily seize control of KCSM’s rail lines and its assets in the event of a natural disaster, war, significant public disturbance or imminent danger to the domestic peace or economy. In such a case, the SCT may restrict KCSM’s ability to exploit the Concession in such manner as the SCT deems necessary under the circumstances, but only for the duration of any of the foregoing events. Mexican law requires that the Mexican government pay compensation if it effects a statutory appropriation for reasons of the public interest. With respect to a temporary seizure due to any cause other than international war, the Mexican Railroad Services Law and regulations provide that the Mexican government will indemnify an affected concessionaire for an amount equal to damages caused and losses suffered. However, these payments may not be sufficient to compensate KCSM for its losses and may not be made timely.
The SCT may revoke the Concession if KCSM is sanctioned on three distinct occasions for unjustly interrupting the operation of its rail lines or for charging tariffs higher than the tariffs it has registered with the SCT. In addition, the SCT may revoke the Concession if, among other things, KCSM is sanctioned on five distinct occasions because KCSM restricts the ability of other Mexican rail operators to use its rail lines; KCSM fails to make payments for damages caused during the performance of services; KCSM fails to comply with any term or condition of the Mexican Railroad Services Law and regulations or the Concession; KCSM fails to make the capital investments required under its five-year business plan filed with the SCT; or KCSM fails to maintain an obligations compliance bond and insurance coverage as specified in the Mexican Railroad Services Law and regulations. In addition, the Concession would revoke automatically if KCSM changes its nationality or assigns or creates any lien on the Concession or if there is a change in control of KCSM without the SCT’s approval. The SCT may also terminate the Concession as a result of KCSM’s surrender of its rights under the Concession, or for reasons of public interest or upon KCSM’s liquidation or bankruptcy. If the Concession is terminated or revoked by the SCT for any reason, KCSM would receive no compensation and its interest in its rail lines and all other fixtures covered by the Concession, as well as all improvements made by it, would revert to the Mexican government. Revocation or termination of the Concession would prevent KCSM from operating its railroad and would materially adversely affect KCSM’s operations and the ability to make payments on its debt as well as materially adversely affect the Company’s consolidated financial statements.
KCSM’s controlling stockholder’s interests may be different from KCSM’s.
KCS is KCSM’s controlling stockholder. The interests of KCS may be different from KCSM’s interests, and KCS may exercise influence over KCSM in a manner inconsistent with KCSM’s interests.
Failure to make capital expenditures could result in the revocation of KCSM’s Concession.
KCSM’s business is capital intensive and requires substantial ongoing expenditures for, among other things, additions and improvements to roadway, structures and technology, acquisitions, and maintenance and repair of equipment and the rail system. KCSM’s failure to make necessary capital expenditures to maintain its operations could impair its ability to serve existing customers, accommodate increases in traffic volumes or result in increased derailments.
KCSM’s Concession from the Mexican government requires KCSM to make investments and undertake capital projects. If KCSM fails to make such capital investments, KCSM’s business plan commitments with the Mexican government may be at risk, requiring KCSM to seek waivers of its business plan. There is no assurance that such waivers, if requested, would be granted by the SCT. KCSM may defer capital expenditures under its business plan with the permission of the SCT. However, the SCT might not grant this permission, and any failure by KCSM to comply with the capital investment commitments in its business plan could result in sanctions imposed by the SCT, and could result in revocation of the Concession if sanctions are imposed on five distinct occasions. The Company cannot assure that the Mexican government would grant any such permission or waiver. If such permission or waiver is not obtained in any instance and KCSM is sanctioned, its Concession might be at risk of revocation, which would materially adversely affect KCSM’s consolidated financial statements. See “KCSM’s Concession is subject to revocation or termination in certain circumstances.”
KCSM has funded, and expects to continue to fund, capital expenditures with operating cash flows, debt and equipment leases. KCSM may not be able to generate sufficient cash flows from its operations or obtain sufficient funds from external sources to fund capital expenditure requirements. Even if financing is available, it may not be obtainable on acceptable terms and within the limitations contained in the indentures and other agreements relating to KCSM’s existing debt.
KCSM is dependent on certain key suppliers of core rail equipment.
KCSM relies on a limited number of suppliers of core rail equipment (including locomotives, rolling stock equipment, rail and ties). The capital intensive nature and complexity of such equipment creates high barriers of entry for any potential new suppliers. If any of KCSM’s suppliers discontinue production or experience capacity or supply shortages, this could result in increased costs or difficulty in obtaining rail equipment and materials, which could have a material adverse effect on the Company’s consolidated financial statements.
KCSM competes against other railroads and other transportation providers.
KCSM’s operations are subject to competition from other railroads, particularly Ferrocarril Mexicano, S.A. de C.V (“Ferromex”) and Ferrosur in Mexico, as well as from truck carriers, barge lines and other maritime shippers. Ferromex is much larger and has significantly greater financial and other resources than KCSM, which may enable KCSM’s rail competitors to reduce rates and make KCSM’s freight services less competitive. KCSM’s ability to respond to competitive pressures by matching rate reductions and decreasing rates without adversely affecting gross margins and operating results will depend on, among other things, the ability to reduce operating costs. KCSM’s failure to respond to competitive pressures, and particularly rate competition, in a timely manner could have a material adverse effect on the Company’s consolidated financial statements.
Trucking, maritime and barge competitors, while able to provide rate and service competition to the railroad industry, are able to use public rights-of-way, require substantially smaller capital investment and maintenance expenditures than railroads and allow for more frequent and flexible scheduling. Continuing competitive pressures, any reduction in margins due to competitive pressures, future improvements that increase the quality of alternative modes of transportation in the locations in which the Company operates, or legislation or regulations that provide motor carriers with additional advantages, such as increased size of vehicles and reduced weight restrictions, could result in downward pressure on freight rates, which in turn could have a material adverse effect on the Company’s consolidated financial statements.
A central part of KCSM’s growth strategy is based upon the conversion of truck traffic to rail. There can be no assurance the Company will succeed in its efforts to convert traffic from truck to rail transport or that the customers already converted will be retained. If the railroad industry in general is unable to preserve its competitive advantages vis-à-vis the trucking industry, revenue growth could be adversely affected. Additionally, revenue growth could be affected by, among other factors, an expansion in the availability, or an improvement in the quality, of the trucking services offered by Mexican carriers resulting from regulatory and administrative interpretations and implementation of certain provisions of NAFTA and KCSM’s inability to grow its existing customer base and capture additional cargo transport market share because of competition from the shipping industry and other railroads.
KCSM’s business strategy, operations and growth rely significantly on agreements with other railroads and third parties.
Operation of KCSM’s rail network and its plans for growth and expansion rely significantly on agreements with other railroads and third parties, including joint ventures and other strategic alliances, as well as interchange, trackage rights, haulage rights and marketing agreements with other railroads and third parties that enable KCSM to exchange traffic and utilize trackage not granted to the Company as part of the Concession. KCSM’s ability to provide comprehensive rail service to its customers depends in large part upon its ability to maintain these agreements with other railroads and third parties, and upon the performance of the obligations under the agreements by the other railroads and third parties. The termination of, or the failure to renew, these agreements could adversely affect KCSM’s consolidated financial statements. KCSM is also dependent in part upon the financial strength and efficient performance of other railroads. There can be no assurance that KCSM will not be materially adversely affected by operational or financial difficulties of other railroads.
KCSM’s operations are subject to certain trackage rights, haulage rights and interline service agreements with another Mexican rail carrier, some of which are in dispute.
Through KCSM’s Concession from the Mexican government, KCSM is required to grant short and long distance trackage rights to Ferromex. Applicable law stipulates that Ferromex similarly is required to grant to KCSM rights to use portions of their tracks. These trackage rights have been granted under the Concession. The rates to be charged for use of the Trackage Rights after January 1, 2009, were agreed to by KCSM and Ferromex pursuant to the Trackage Rights Agreement, dated February 9, 2010. The Trackage Rights Agreement did not establish rates that may be charged for the right to use the trackage rights for the periods beginning in 1998 through December 31, 2008.
If KCSM cannot reach an agreement with Ferromex for rates applicable for services provided prior to January 1, 2009, which are not subject to the Trackage Rights Agreement, the SCT is entitled to set the rates in accordance with Mexican law and regulations, which rates may not adequately compensate the Company. KCSM is currently involved in legal proceedings with the SCT and discussions with Ferromex regarding the amounts payable to each other for trackage rights, interline services and haulage rights for periods prior to January 1, 2009. Certain of these disputes continue under litigation. Any resolution of such procedures adverse to KCSM could have a material adverse effect on its consolidated financial statements in a particular quarter or fiscal year.
KCSM depends on the stability, availability and security of its information technology systems to operate its business.
KCSM relies on information technology in all aspects of its business. A significant disruption or failure of its information technology systems, including its computer hardware, software and communications equipment, could result in service interruptions, safety failures, security failures, regulatory compliance failures or other operational difficulties.
The security risks associated with information technology systems have increased in recent years because of the increased sophistication and activities of perpetrators of cyber attacks. A failure in or breach of KCSM’s information technology security systems, or those of its third party service providers, as a result of cyber attacks or unauthorized access to its network could disrupt KCSM’s business, result in the disclosure or misuse of confidential or proprietary information, increase its costs and/or cause losses. KCSM also confronts the risk that a terrorist or other third parties may seek to use its property, including KCSM’s information technology systems, to inflict major harm.
KCSM continually takes steps to make appropriate enhancements to its information technology systems; however, KCSM’s systems may be vulnerable to disruption, failure or unauthorized access which could have a material adverse effect on KCSM’s consolidated financial statements.
KCSM’s business may be adversely affected by changes in general economic, weather or other conditions.
KCSM’s operations may be adversely affected by changes in the economic conditions of the industries and geographic areas that produce and consume the freight that KCSM transports. The relative strength or weakness of the United States and Mexican economies affects the businesses served by KCSM. Prolonged negative changes in domestic and global economic conditions or disruptions of either or both of the financial and credit markets, including the availability of short and long-term debt financing, may affect KCSM, as well as the producers and consumers of the commodities that KCSM transports and may have a material adverse effect on KCSM’s consolidated financial statements.
The transportation industry is highly cyclical, generally tracking the cycles of the world economy. Although transportation markets are affected by general economic conditions, there are numerous specific factors within each particular market that may influence operating results. Some of KCSM’s customers do business in industries that are highly cyclical, including the oil and gas, automotive, housing and agriculture industries. Any downturn in these industries could have a material adverse effect on operating results. Also, some of the products transported have had a historical pattern of price cyclicality which has typically been influenced by the general economic environment and by industry capacity and demand. KCSM cannot assure that prices and demand for these products will not decline in the future, adversely affecting those industries and, in turn, the Company's consolidated financial statements.
Traffic congestion experienced in the U.S. or Mexican railroad system may result in overall traffic congestion which would impact the ability to move traffic to and from Mexico and adversely affect KCSM’s operations. This system congestion may also result in certain equipment shortages. Any similar congestion experienced by railroads in Mexico could have an adverse effect on the Company’s consolidated financial statements. In addition, the growth of cross border traffic in recent years has contributed to congestion on the international bridge at the Nuevo Laredo-Laredo border gateway, which is expected to continue in the near future. This may adversely affect KCSM’s consolidated financial statements.
KCSM’s operations may also be affected by natural disasters or adverse weather conditions. The Company operates in and along the Gulf of Mexico, and its facilities may be adversely affected by hurricanes, floods and other extreme weather conditions that could also adversely affect KCSM’s shipping, agricultural, chemical and other customers. Significant reductions in the volume of rail shipments due to economic, weather, or other conditions could have a material adverse effect on KCSM’s consolidated financial statements.
KCSM’s business may be affected by market and regulatory responses to climate change.
KCSM’s operations may be adversely affected by restrictions, caps, taxes, or other controls on emissions of greenhouse gases, including diesel exhaust. Restrictions on emissions could also affect KCSM’s customers that use commodities that KCSM transports to produce energy, use significant amounts of energy in producing or delivering the commodities KCSM transports, or manufacture or produce goods that consume significant amounts of energy or burn fossil fuels, including coal-fired power plants, chemical producers, farmers and food producers, and automakers and other manufacturers. Significant cost increases, government regulation, or changes of consumer preferences for goods or services relating to alternative sources of energy or emissions reductions could materially affect the markets for the commodities KCSM transports, which in turn could have a material adverse effect on KCSM’s consolidated financial statements. Government incentives encouraging the use of alternative sources of energy could also affect certain customers and their respective markets for certain commodities KCSM transports in an unpredictable manner that could alter traffic patterns, including, for example, the impacts of ethanol incentives on farming and ethanol producers. Any of these factors, individually or in conjunction with one or more of the other factors, or other unforeseen impacts of climate change could have a material adverse effect on KCSM’s consolidated financial statements.
KCSM is exposed to the credit risk of its customers and counterparties, and their failure to meet their financial obligations could adversely affect KCSM’s consolidated financial statements.
KCSM’s business is subject to credit risk including the risk that a customer or counterparty will fail to meet its obligations when due. Customers and counterparties that owe the Company money may default on their obligations to the Company due to bankruptcy, lack of liquidity, operational failure or other reasons. Although the Company has procedures for reviewing its credit exposures to specific customers and counterparties to address present credit concerns, default risk may arise from events or circumstances that are difficult to detect or foresee. Some of the Company’s risk management methods depend upon the evaluation of information regarding markets, clients or other matters that are publicly available or otherwise accessible by the Company. That information may not, in all cases, be accurate, complete, up-to-date or properly evaluated. In addition, concerns about, or a default by, one customer or counterparty could lead to significant liquidity problems, losses or defaults by other customers or counterparties, which in turn could adversely affect the Company. The Company may be materially and adversely affected in the event of a significant default by its customers and counterparties.
KCSM’s business is subject to regulation by international, federal, state and local regulatory agencies, including environmental, health, safety laws and regulations and tax that could require KCSM to incur material costs or liabilities.
In the operation of a railroad, it is possible that derailments or other accidents may occur that could cause harm to the environment or to human life or health. As a result, KCSM may incur costs in the future, which may be material, to address any such harm, including costs relating to the performance of clean-ups, natural resources damages and compensatory or punitive damages for harm to property or individuals.
KCSM’s operations are subject to Mexican federal and state laws and regulations relating to the protection of the environment, including standards for, among other things, water discharge, water supply, emissions, noise pollution, hazardous substances and transportation and handling of hazardous and solid waste. Under applicable Mexican law and regulations, administrative and criminal proceedings may be brought and economic sanctions imposed against companies that violate environmental laws and non-complying facilities may be temporarily or permanently closed. KCSM is also subject to the laws of various jurisdictions and international conferences with respect to the discharge of materials into the environment and to environmental laws and regulations issued by the governments of each of the Mexican states in which KCSM’s facilities are located. The terms of KCSM’s Concession from the Mexican government also impose environmental compliance obligations on KCSM. The Company cannot predict the effect, if any, that unidentified environmental matters or the adoption of additional or more stringent environmental laws and regulations would have on KCSM’s consolidated financial statements. Failure to comply with any environmental laws or regulations may result in the termination of KCSM’s Concession or in fines or penalties that may affect profitability.
KCSM is subject to income taxes as well as non-income based taxes in Mexico. Changes in tax rates, enactment of new tax laws and revisions of tax regulations could have a material adverse effect on the Company’s consolidated financial statements. Additionally, the final determination of tax audits, claims or litigation could differ from what is reflected in KCSM’s financial statements.
KCSM, as a common carrier by rail, is required by Mexican law to transport hazardous materials, which could expose KCSM to significant costs and claims.
Under applicable Mexican laws, KCSM’s common carrier responsibility requires it to transport hazardous materials. Any rail accident or other incident or accident on KCSM’s network, facilities, or at the facilities of KCSM’s customers involving the release of hazardous materials, including toxic inhalation hazard (or TIH) materials, could involve significant costs and claims for personal injury, property damage, and environmental penalties and remediation in excess of the Company's insurance coverage for these risks, which could have a material adverse effect on KCSM’s consolidated financial statements.
KCSM’s business is vulnerable to rising fuel costs and disruptions in fuel supplies. Any significant increase in the cost of fuel that is not adequately covered by fuel surcharges, or severe disruption of fuel supplies, would have a material adverse effect on KCSM’s consolidated financial statements.
KCSM incurs substantial fuel costs in its railroad operations and these costs represent a significant portion of its transportation expenses. Significant price increases for fuel may have a material adverse effect on KCSM’s operating results. If KCSM is unable to recapture its costs of fuel from its customers, operating results could be materially adversely affected. In addition, a severe disruption of fuel supplies resulting from supply shortages, political unrest, a disruption of oil imports, weather events, war or otherwise, and the resulting impact on fuel prices could materially adversely affect KCSM’s consolidated financial statements.
KCSM currently meets, and expects to continue to meet, fuel requirements for its operations almost exclusively through purchases at market prices from PEMEX Refinación (“PEMEX”), the national oil company of Mexico, a government-owned entity exclusively responsible for the distribution and sale of diesel fuel in Mexico. KCSM is party to a fuel supply contract with PEMEX of indefinite duration based on market prices. Either party may terminate the contract upon 30 days written notice to the other at any time. If the fuel contract is terminated and KCSM is unable to acquire diesel fuel from alternate sources on acceptable terms, its operations could be materially adversely affected.
Market fluctuations could adversely impact KCSM's operating results as it hedges certain transactions.
From time to time, KCSM may use various financial instruments to reduce its exposure to various market risks, including interest rates, foreign currency, and fuel and commodity prices. While these financial instruments reduce the Company's exposure to changes in market risks, the use of such instruments may ultimately limit the Company's ability to benefit from favorable changes in underlying rates or prices due to amounts fixed at the time of entering into the hedge agreement.
The loss of key personnel could negatively affect business.
KCSM's success substantially depends on its ability to attract and retain key members of the senior management team. Recruiting, motivating, and retaining qualified management personnel, particularly those with expertise in the railroad industry, are vital to operations and success. There is substantial competition for qualified management personnel and there can be no assurance that KCSM will always be able to attract or retain qualified personnel. Employment agreements with senior management are terminable at any time by either party. If KCSM loses one or more of these key executives or principals, its ability to successfully implement its business plans could be materially adversely affected.
A majority of the employees contracted by KCSM belong to a labor union. Strikes or work stoppages could adversely affect operations.
KCSM Servicios is a party to a collective bargaining agreement with a labor union in Mexico. As of December 31, 2012, approximately 80% of KCSM Servicios’ employees were covered by a labor contract subject to collective bargaining. KCSM Servicios may be subject to, among other things, strikes, work stoppages or work slowdowns as a result of disputes under this collective bargaining agreement and labor contract or KCSM Servicios’s potential inability to negotiate an acceptable contract with this union. If the unionized workers of KCSM Servicios were to engage in a strike, work stoppage or other slowdown; or if the terms and conditions in future labor agreements were renegotiated, KCSM could experience a significant disruption of its operations and higher ongoing labor costs which could have a material adverse effect on its consolidated financial statements.
KCSM faces possible catastrophic loss and liability, and its insurance may not be sufficient to cover its damages or damages to others.
The operation of any railroad carries with it an inherent risk of catastrophe, mechanical failure, collision and property loss. In the course of KCSM’s operations, spills or other environmental mishaps, cargo loss or damage, business interruption due to political developments, as well as labor disputes, strikes and adverse weather conditions, could result in a loss of revenues or increased liabilities and costs. Collisions, environmental mishaps or other accidents can cause serious bodily injury, death and extensive property damage, particularly when such accidents occur in heavily populated areas. Additionally, KCSM’s operations may be affected from time to time by natural disasters such as earthquakes, volcanoes, floods, hurricanes or other storms. The occurrence of a major natural disaster, especially in the Mexico City area, which is the site of Ferrocarril y Terminal del Valle de México, S.A. de C.V. (“FTVM”) and significant portions of KCSM’s customer base, could have a material adverse effect on KCSM’s consolidated financial statements. The Company maintains insurance that is consistent with industry practice and in compliance with the requirements of its Concession against the accident-related risks involved in the conduct of its business, property damage and business interruption due to natural disasters. However, this insurance is subject to a number of limitations on coverage, depending on the nature of the risk insured against. This insurance may not be sufficient to cover KCSM’s damages or damages to others, and this insurance may not continue to be available at commercially reasonable rates. In addition, KCSM is subject to the risk that one or more of its insurers may become insolvent and would be unable to pay a claim that may be made in the future. Even with insurance, if any catastrophic interruption of service occurs, KCSM may not be able to restore service without a significant interruption to operations, which could have an adverse effect on KCSM’s consolidated financial statements.
KCSM’s business may be affected by future acts of terrorism, war or other acts of violence or crime.
Terrorist attacks, such as an attack on the Company’s chemical transportation activities, any government response thereto and war or risk of war may adversely affect KCSM’s consolidated financial statements. These acts may also impact the Company’s ability to raise capital or its future business opportunities. KCSM’s rail lines and facilities could be direct targets or indirect casualties of acts of terror, which could cause significant business interruption and damage to KCSM’s property. In recent years, there have been reported incidents of train-related robberies in Mexico, including incidents involving KCSM’s trains and infrastructure. Other acts of violence or crime could also adversely affect the Company’s business.
As a result, acts of terrorism or war or acts of crime or violence could result in increased costs and liabilities and decreased revenues for KCSM. In addition, insurance premiums charged for some or all of the applicable coverage currently maintained by KCSM could increase dramatically or certain coverage may not be adequate to cover losses or may not be available in the future.
KCSM’s operations are subject to economic and political risks.
The Mexican government has exercised, and continues to exercise, significant influence over the Mexican economy. Accordingly, Mexican governmental actions concerning the economy and state-owned enterprises could have a significant impact on Mexican private sector entities in general and on KCSM’s operations in particular. KCSM cannot predict the impact that the political landscape, including multiparty rule, will have on the Mexican economy. Furthermore, KCSM’s consolidated financial statements and prospects may be affected by currency fluctuations, inflation, interest rates, regulation, taxation and other political, social and economic developments in or affecting Mexico.
The Mexican economy in the past has suffered balance of payment deficits and shortages in foreign exchange reserves. Although Mexico has imposed foreign exchange controls in the past, there are currently no exchange controls in Mexico. Pursuant to the provisions of NAFTA, if Mexico experiences serious balance of payment difficulties or the threat of such difficulties in the future, Mexico would have the right to impose foreign exchange controls on investments made in Mexico, including those made by United States and Canadian investors. Any restrictive exchange control policy could adversely affect KCSM’s ability to obtain U.S. dollars or to convert Mexican pesos (“pesos” or “Ps.”) into dollars for purposes of making interest and principal payments due on indebtedness, to the extent KCSM may have to effect those conversions. This could have a material adverse effect on KCSM’s consolidated financial statements.
Presidential and federal congress elections in Mexico were held resulting in a change in administration in December 2012. KCSM cannot predict whether changes in Mexican government policy will result from the change in administration; however, changes in laws, public policies and government programs could be enacted, which could have an adverse effect on KCSM’s consolidated financial statements.
Mexican national politicians are currently focused on certain regional political and social tensions, and reforms regarding fiscal policies, gas, electricity, social security and oil have not been and may not be approved. The social and political situation in Mexico could adversely affect the Mexican economy, which in turn could have a material adverse effect on KCSM’s consolidated financial statements.
Downturns in the United States economy or in trade between Mexico and the United States or Asia and fluctuations in the peso-dollar exchange rates would likely have adverse effects on KCSM’s consolidated financial statements.
The level and timing of KCSM’s activity is heavily dependent upon the level of Mexican-United States trade and the effects of NAFTA on such trade. KCSM’s operations depend on Mexican and United States markets for the products KCSM transports, the relative position of Mexico and the United States in these markets at any given time, and tariffs or other barriers to trade. Downturns in the Mexican or United States economies or in trade between Mexico and the United States would likely have adverse effects on KCSM’s consolidated financial statements and its ability to meet debt service obligations. In addition, KCSM has invested significant amounts in developing its intermodal operations, including the Port of Lazaro Cardenas, in part to provide Asian importers with an alternative to the west coast ports of the United States, and the level of intermodal traffic depends, to an extent, on the volume of Asian shipments routed through Lazaro Cardenas. Reduction in trading volumes, which may be caused by factors beyond KCSM’s control, including increased government regulations in light of recent concerns regarding the safety and quality of Asian-manufactured products, may adversely affect KCSM’s consolidated financial statements.
Also, fluctuations in the peso-dollar exchange rates could lead to shifts in the types and volumes of Mexican imports and exports. Although a decrease in the level of exports of some of the commodities that KCSM transports to the United States may be offset by a subsequent increase in imports of other commodities KCSM hauls into Mexico and vice versa, any offsetting increase might not occur on a timely basis, if at all. Future developments in Mexican-United States trade beyond KCSM’s control may result in a reduction of freight volumes or in an unfavorable shift in the mix of products and commodities KCSM carries.
Severe devaluation or depreciation of the peso may result in disruption of the international foreign exchange markets and may limit the ability to transfer pesos or to convert pesos into U.S. dollars for the purpose of making timely payments of interest and principal on the non-peso denominated indebtedness. Although the Mexican government currently does not restrict, and for many years has not restricted, the right or ability of Mexican or foreign persons or entities to convert pesos into U.S. dollars or to transfer foreign currencies out of Mexico, the Mexican government could, as in the past, institute restrictive exchange rate policies that could limit the ability to transfer or convert pesos into U.S. dollars or other currencies for the purpose of making timely payments of the U.S. dollar-denominated debt and contractual commitments.
Fluctuations in the peso-dollar exchange rates also have an effect on KCSM’s consolidated financial statements. A devaluation of the peso would cause reported peso-denominated revenues and expenses to decrease, and would increase reported foreign exchange loss due to the Company’s net monetary assets that are peso-denominated. Exchange rate variations also affect the calculation of taxes under Mexican income tax law, and an appreciation of the peso would cause an increase in the Company’s reported income tax provision and effective income tax rate.
Mexico may experience high levels of inflation in the future which could adversely affect KCSM’s consolidated financial statements.
Mexico has a history of high levels of inflation and may experience high inflation in the future. During most of the 1980s and during the mid and late 1990s, Mexico experienced periods of high levels of inflation. The annual rates of inflation for the last three years, as measured by changes in the National Consumer Price Index, as provided by Banco de México, were 3.6% in 2012, 3.8% in 2011 and 4.4% in 2010. A substantial increase in the Mexican inflation rate would have the effect of increasing some of KCSM’s costs, which could adversely affect its consolidated financial statements. High levels of inflation may also affect the balance of trade between Mexico and the United States, and other countries, which could adversely affect KCSM’s consolidated financial statements.
KCSM may be subject to various claims and litigation that could have a material adverse effect on KCSM's consolidated financial statements.
The Company may be exposed to the potential of various claims and litigation related to labor and employment, personal injury, commercial disputes, freight loss and other property damage, and other matters that arise in the normal course of business. Any material changes to litigation trends or a catastrophic rail accident or series of accidents involving any or all of property damage, personal injury and environmental liability could have a material adverse effect on KCSM's consolidated financial statements.
Item 1B.
Item 1B.
Unresolved Staff Comments
None.
Item 2.
Item 2.
Properties
KCSM’s headquarters, which the Company leases, are located at Montes Urales 625, Col. Lomas de Chapultepec, C.P. 11000 Mexico, D.F., Mexico. KCSM also has offices that are part of the Concession, and they are located at Av. Manuel L. Barragan 4850 Norte, Colonia Hidalgo, C.P. 64420, Monterrey Nuevo Leon, Mexico.
Track Configuration
Under its Concession from the Mexican government, KCSM has the right to operate approximately 3,200 route miles but does not own the land, roadway or associated structures, and additionally has approximately 700 miles of trackage rights that permit KCSM to operate its crews over other railroads’ tracks. The Concession requires KCSM to make investments as described in a business plan filed every five years with the Mexican government. See Item 1A, “Risk Factors - KCSM’s Concession is subject to revocation or termination in certain circumstances which would prevent KCSM from operating its railroad and would have a material adverse effect on the Company’s consolidated financial statements.”
Equipment Configuration
As of December 31, 2012 and 2011, KCSM leased and owned the following units of equipment:
Property and Facilities
KCSM operates numerous facilities, including terminals for intermodal and other freight, rail yards for train-building, switching, storage-in-transit (the temporary storage of customer goods in rail cars prior to shipment) and other activities; offices to administer and manage operations; dispatch centers to direct traffic on the rail network; crew quarters to house train crews along the rail line; and shops and other facilities for fueling, maintenance, and repair of locomotives and maintenance of freight cars and other equipment.
Capital Expenditures
The Company’s cash capital expenditures for the two years ended December 31, 2012 and 2011, and planned 2013 capital expenditures are included in Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Liquidity and Capital Resources - Capital Expenditures”. See also Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates - Capitalization, Depreciation and Amortization of Property and Equipment (including Concession Assets)” regarding the Company’s policies and guidelines related to capital expenditures.
Item 3.
Item 3.
Legal Proceedings
The Company is subject to various legal proceedings and claims that arise in the ordinary course of business. For more information on legal proceedings, see Item 1A, “Risk Factors - KCSM may be subject to various claims and litigation that could have a material adverse effect on KCSM's consolidated financial statements” and Item 8, “Financial Statements and Supplementary Data - Note 12 Commitments and Contingencies.”
Item 4.
Item 4.
Mine Safety Disclosures
Not applicable.
Part II
Item 5.
Item 5.
Market for the Company’s Common Equity, Related Stockholder Matters and Issuer Purchases
of Equity Securities
Market Information
There is no public trading market for KCSM’s equity securities. All of its equity securities are indirectly owned by KCS.
Dividend Policy
Pursuant to KCSM’s outstanding indentures and credit agreement, the Company can pay cash dividends permitted by applicable law, subject to certain limitations.
Item 6.
Item 6.
Selected Financial Data
Omitted pursuant to General Instruction I(2) to Form 10-K.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following is a discussion of KCSM’s results of operations, certain changes in its financial position, liquidity, capital structure and business developments for the relevant periods and is based on KCSM’s consolidated financial statements included under Item 8 of this Form 10-K. This discussion should be read in conjunction with the included consolidated financial statements, the related notes, and other information included in this report.
CAUTIONARY INFORMATION
The discussions set forth in this Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, management may make forward-looking statements orally or in other writings, including, but not limited to, in press releases, executive presentations and in other filings with the Securities and Exchange Commission. Readers can identify these forward-looking statements by the use of such verbs as “expects,” “anticipates,” “believes” or similar verbs or conjugations of such verbs. These statements involve a number of risks and uncertainties. Actual results could materially differ from those anticipated by such forward-looking statements. Such differences could be caused by a number of factors or combination of factors including, but not limited to, those discussed under Item 1A of this Form 10-K, “Risk Factors.” Readers are strongly encouraged to consider these factors when evaluating any forward-looking statements concerning the Company.
EXECUTIVE SUMMARY
2012 Financial Overview
In 2012, KCSM recognized record-high volumes and revenues. Record-breaking revenues of $1.0 billion were driven by strong growth in intermodal and automotive traffic. As revenues grew in most of the business units during the year, the Company’s continued focus on operating expense control resulted in operating expenses as a percentage of revenues of 60.5%.
Revenues in 2012 increased 9% over 2011, driven primarily by an increase in carload/unit volumes, positive pricing impacts and increased fuel surcharge, partially offset by the effect of fluctuations in the value of the Mexican peso against the U.S. dollar for revenues denominated in Mexican pesos.
Operating expenses decreased $3.2 million during 2012, compared to 2011, primarily due to the elimination of deferred statutory profit sharing liability of $43.0 million as a result of the organizational restructuring in the second quarter of 2012. In addition, operating expenses decreased due to the effect of fluctuations in the value of the Mexican peso against the U.S. dollar for operating expenses denominated in Mexican pesos. These decreases were partially offset by higher diesel fuel prices, carload/unit volumes and the $14.8 million gain on insurance recoveries recognized in 2011.
KCSM’s revenues and operating expenses are affected by fluctuations in the value of the Mexican peso against the U.S. dollar. Based on the volume of revenue and expense transactions denominated in Mexican pesos, revenue and expense fluctuations generally offset, with insignificant net impacts to operating income.
The Company reported consolidated net income of $191.2 million for the year ended December 31, 2012, compared to $173.9 million for 2011.
During 2012, the Company further strengthened its financial position by amending its credit facility, which extended the maturity date, eliminated or modified a number of restrictive covenants in its facility in order to achieve consistency between its facility and firms with investment grade ratings, and allows the facility to convert from secured to unsecured obligations upon attainment of investment grade credit ratings.
RESULTS OF OPERATIONS
Year Ended December 31, 2012, compared to the Year Ended December 31, 2011
The following summarizes KCSM’s consolidated income statement components (in millions):
Revenues
The following summarizes revenues (in millions), carload/unit statistics (in thousands) and revenue per carload/unit:
Freight revenues include both revenue for transportation services and fuel surcharges. For the year ended December 31, 2012, revenues increased $83.3 million compared to 2011, primarily due to the overall increase in carload/unit volumes, positive pricing impacts and increased fuel surcharge, partially offset by the effect of fluctuations in the value of the Mexican peso against the U.S. dollar for revenues denominated in Mexican pesos. Revenue per carload/unit was flat for the year ended December 31, 2012, compared to the same period in 2011.
KCSM’s fuel surcharge is a mechanism to adjust revenue based upon changing fuel prices. Fuel surcharge is calculated using a fuel price from a prior time period that can be up to 60 days earlier. In a period of volatile fuel prices or changing customer business mix, changes in fuel expense and fuel surcharge may differ.
The following discussion provides an analysis of revenues by commodity group:
Revenues by commodity group
for 2012
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Chemical and petroleum. Revenues increased $7.2 million for the year ended December 31, 2012, compared to 2011, primarily due to increases in pricing and fuel surcharge, partially offset by fluctuations in the value of the Mexican peso against the U.S. dollar and decreases in volume. Revenues increased due to positive pricing impacts for plastics and chemicals used to manufacture glass and paint. Petroleum volumes decreased primarily due to a customer’s lost business.
Industrial and consumer products. Revenues increased $23.9 million for the year ended December 31, 2012, compared to 2011, primarily due to increases in pricing, volume and fuel surcharge. Metals and scrap revenues grew primarily due to increases in pricing and high demand for slab and steel coil driven by strength in the automotive and oil and gas industries.
Agriculture and mineral. Revenues decreased $13.3 million for the year ended December 31, 2012, compared to 2011, primarily due to decreases in volume and fluctuations in the value of the Mexican peso against the U.S. dollar, partially offset by an increase in pricing. Food products volumes decreased due to lost cross border corn syrup business and lower dried distillers grain volume. In addition, grain volumes decreased primarily as a result of the severe drought conditions experienced in the United States.
Revenues by commodity group
for 2012
________________________________________
Intermodal. Revenues increased $36.5 million for the year ended December 31, 2012, compared to 2011, primarily due to increases in volume due to strong cross border auto parts business, conversion of truck traffic to rail and Trans-Pacific imports via the Port of Lazaro Cardenas.
Automotive. Revenues increased $30.8 million for the year ended December 31, 2012, compared to 2011, primarily due to increases in volume and pricing, partially offset by fluctuations in the value of the Mexican peso against the U.S. dollar. The increase was driven by strong year over year growth in North American automobile sales for Original Equipment Manufacturers, increased import/export volume through the Port of Lazaro Cardenas and increased length of haul through new cross border vehicle routings.
Operating Expenses
Operating expenses, as shown below (in millions), decreased $3.2 million for the year ended December 31, 2012, when compared to 2011, primarily due to the elimination of the deferred statutory profit sharing liability as a result of the organizational restructuring in 2012. In addition, operating expenses decreased due to fluctuations in the value of the Mexican peso against the U.S. dollar for operating expenses denominated in Mexican pesos. These decreases were partially offset by higher diesel fuel prices and carload/unit volumes and the gain on insurance recoveries recognized in 2011.
As a result of the organizational restructuring in 2012, KCSM pays KCSM Servicios, a wholly-owned subsidiary of KCS, market-based rates for employee services. This market-based rate was determined by applying a percentage mark-up to amounts paid by KCSM Servicios to its employees and vendors. For comparative purposes, amounts paid to KCSM Servicios are classified according to the nature of the services provided to KCSM and the percentage mark-up portion of payments to KCSM Servicios is included within materials and other expense.
Compensation and benefits. Compensation and benefits decreased $4.8 million for the year ended December 31, 2012, compared to 2011, primarily due to a decrease in statutory profit sharing expense as a result of the organizational restructuring in the second quarter of 2012. In addition, compensation and benefits decreased due to fluctuations in the value of the Mexican peso against the U.S. dollar. These decreases were partially offset by annual salary and benefit rate increases and higher carload / units volumes.
Purchased services. Purchased services expense increased $13.0 million for the year ended December 31, 2012, compared to 2011, due to higher net joint facility income related to non-recurring usage of certain trackage rights recognized during the second half of 2011 and increases in volume-sensitive costs, primarily locomotive maintenance expense and security services.
Fuel. Fuel expense increased $13.5 million for the year ended December 31, 2012, compared to 2011, primarily due to higher diesel fuel prices, higher consumption and decreased fuel efficiency. These increases were partially offset by the fluctuations in the value of the Mexican peso against the U.S. dollar. The net average fuel price per gallon increased by approximately 4% in 2012 as compared to 2011.
Equipment costs. Equipment costs decreased $5.3 million for the year ended December 31, 2012, compared to 2011, primarily due to lower locomotive lease expense due to the acquisition of 75 locomotives during the third quarter of 2011, which were previously leased by the Company under an operating lease agreement. This decrease was partially offset by an increase in intermodal freight equipment rent and the use of other railroads’ freight cars due to increased traffic volumes.
Depreciation and amortization. Depreciation and amortization expense increased $4.5 million for the year ended December 31, 2012, compared to 2011, primarily due to a larger asset base.
Materials and other. Materials and other expense increased $4.1 million for the year ended December 31, 2012, compared to 2011, primarily due to the percentage mark-up paid to KCSM Servicios as a result of the organizational restructuring in the second quarter of 2012 and increased concession duty rate, partially offset by decreased casualty expense. KCSM paid concession duty expense of 0.5% of gross revenues for the first 15 years of the Concession period, and on June 24, 2012, KCSM began paying 1.25% of gross revenues, which is effective for the remaining years of the Concession.
Elimination of deferred statutory profit sharing liability, net. As a result of the organizational restructuring in 2012, KCSM’s obligation to pay statutory profit sharing terminated as of May 1, 2012 and accordingly, KCSM recognized a $43.0 million net reduction to operating expense. This reduction includes the elimination of $47.8 million of the deferred statutory profit sharing liability, net of $4.8 million of transaction costs.
Gain on insurance recoveries related to hurricane damage. In 2011, the Company settled its insurance claims related to 2010 hurricane damage and recognized a $14.8 million gain on insurance recoveries which primarily represented the recovery of lost profits and the replacement value of property in excess of its carrying value, net of the self-insured retentions.
Non-Operating Expenses
Equity in net earnings of unconsolidated affiliates. Equity in earnings from the operations of FTVM was $3.2 million and $2.8 million for the years ended December 31, 2012 and 2011, respectively. This increase was primarily due to an increase in volumes.
Interest expense. Interest expense increased $8.2 million for the year ended December 31, 2012, compared to 2011, primarily due to higher average debt balances, partially offset by lower average interest rates. For the years ended December 31, 2012 and 2011, the average debt balance was $1,179.3 million and $973.8 million, respectively.
Debt retirement costs. Debt retirement costs were $0.5 million and $10.3 million for the years ended December 31, 2012 and 2011, respectively. During the fourth quarter of 2012, KCSM entered into an amended and restated credit agreement and recognized $0.5 million in debt issuance costs related to the amended credit agreement. During 2011, KCSM purchased and redeemed the remaining $32.4 million principal amount and all of the outstanding $165.0 million aggregate principal amount of its 7 5/8% Senior Notes due December 1, 2013, and 7 3/8% Senior Notes due June 1, 2014, respectively. KCSM recognized debt retirement costs of $10.3 million related to the call and tender premiums and the write-off of unamortized debt issuance costs.
Foreign exchange gain (loss). Fluctuations in the value of the Mexican peso against the U.S. dollar for the years ended December 31, 2012 and 2011, resulted in a foreign exchange gain of $3.0 million and a foreign exchange loss of $9.6 million, respectively.
Other income (loss), net. Other income (loss), net decreased $2.8 million for the year ended December 31, 2012, compared to 2011. This decrease was primarily attributable to miscellaneous income.
Income tax expense. Income tax expense increased $81.0 million for the year ended December 31, 2012, compared to 2011, primarily due to higher pre-tax income and an increased effective tax rate due to fluctuations in the foreign exchange rate. The effective income tax rate was 40.4% for the year ended December 31, 2012, compared to 21.8% for 2011.
LIQUIDITY AND CAPITAL RESOURCES
Overview
In recent years, KCSM has improved its financial strength and flexibility by extending debt maturities. In 2012, KCSM completed an amendment to its credit facility which extended the maturity date, eliminated or modified a number of restrictive covenants in its facility in order to achieve consistency between its facility and firms with investment grade ratings and allows for the facility to convert from secured to unsecured obligations upon attainment of investment grade credit ratings.
Though KCSM’s cash flows from operations are sufficient to fund operations, capital expenditures and debt service, the Company may, from time to time, use external sources of cash (principally bank debt, public and private debt, and leases) to refinance existing indebtedness and to fund new investments and equipment additions. On December 31, 2012, total available liquidity (the unrestricted cash balance plus revolving credit facility availability) was $209.2 million, compared to available liquidity at December 31, 2011 of $215.7 million.
The Company believes, based on current expectations, that cash and other liquid assets, operating cash flows, access to debt capital markets and other available financing resources will be sufficient to fund anticipated operating, capital and debt service requirements and other commitments in the foreseeable future.
KCSM’s primary sources of liquidity are cash flows generated from operations, borrowings under its revolving credit facility and access to debt capital markets. Although KCSM has had adequate access to capital markets, the financial terms under which funding has been obtained contain restrictive covenants, which limit or preclude certain actions, including, but not limited to, the ability to incur additional debt for any purpose other than refinancing existing debt, create or suffer to exist additional liens, make prepayments of particular debt, make certain investments, engage in transactions with stockholders and affiliates, sell certain assets and engage in mergers and consolidations or in sale-leaseback transactions. The KCSM revolving credit facility contains additional negative covenants, including but not limited to, KCSM’s ability to freely deploy proceeds in excess of pre-defined thresholds from insurance settlements. The aforementioned negative covenant terminates upon conversion of KCSM’s revolving credit facility from secured to unsecured upon KCSM’s attainment of investment grade credit ratings from at least two of the three primary rating agencies. Though these covenants may restrict or prohibit certain activities, the covenants contain a number of qualifications, thresholds and exceptions that provide the Company with what management believes is a sufficient degree of flexibility to conduct its operations. The Company was in compliance with all of its debt covenants as of December 31, 2012.
KCSM’s operating results and financing alternatives can be unexpectedly impacted by various factors, some of which are outside of its control. For example, if KCSM was to experience a reduction in revenues or a substantial increase in operating costs or other liabilities, its earnings could be significantly reduced, increasing the risk of non-compliance with debt covenants. Additionally, KCSM is subject to external factors impacting debt and capital markets and its ability to obtain financing under reasonable terms is subject to market conditions. Volatility in capital markets and the tightening of market liquidity could impact KCSM’s access to capital. Further, KCSM’s cost of debt can be impacted by independent rating agencies, which assign debt ratings based on certain factors including credit measurements such as interest coverage and leverage ratios, liquidity and competitive position.
Three credit rating agencies provide their views of the Company's outlook and ratings. In the third quarter of 2012, Fitch initiated coverage of KCSM and upgraded KCSM's Issuer Default Rating and senior unsecured debt rating to investment grade. S&P rates the secured KCSM agreement as investment grade but the remaining debt and corporate credit of KCSM as non-investment grade. In the fourth quarter of 2012, Moody's upgraded the rating on the secured KCSM agreement to investment grade. Moody's rates the remaining debt and corporate credit of KCSM as non-investment grade. Ratings and outlooks change from time to time and can be found on the websites of S&P, Moody's and Fitch.
Cash Flow Information
The following table summarizes cash flow data for the years ended December 31, 2012 and 2011 (in millions):
During 2012, cash and cash equivalents decreased $6.5 million as increased cash flows from operating activities were used to fund net investing activities and to reduce outstanding debt.
Operating Cash Flows. Net operating cash flows for 2012 increased $21.1 million to $277.1 million. The increase in operating cash flows was primarily a result of increased net income. This increase was partially offset by insurance proceeds of $40.2 million related to 2010 hurricane damage received during 2011.
Investing Cash Flows. Net investing cash outflows were $205.3 million and $129.4 million during 2012 and 2011, respectively. This $75.9 million increase was primarily due to an increase in capital expenditures and the insurance proceeds received during 2011 related to 2010 hurricane damage.
Financing Cash Flows. Financing cash inflows were generated by a capital contribution from the Company's shareholders and proceeds from related company debt. Financing cash outflows were used for the repayment of debt. Financing cash flows for 2012 and 2011 are discussed in more detail below:
•
Net financing cash outflows for 2012 were $78.3 million. During 2012, the Company paid $87.2 million of related company debt and repaid $18.1 million of outstanding debt. During the year, the Company received $18.8 million of proceeds of capital contribution from the Company's shareholders and $9.0 million in proceeds from a borrowing from a wholly-owned subsidiary of KCS.
•
Net financing cash outflows for 2011 were $147.9 million. During 2011, the Company repaid $214.8 million of outstanding debt and paid $135.0 million of capital distributions to the Company’s shareholders. During the year, the Company received net proceeds of $200.0 million from the issuance of the 61/8% senior unsecured notes due June 15, 2012 (the “61/8% Senior Notes”) and $17.5 million related to a borrowing from a wholly-owned subsidiary of KCS. Debt issue costs of $15.6 million were paid in connection with the 61/8% Senior Notes.
Capital Expenditures
KCSM has funded, and expects to continue to fund, capital expenditures with operating cash flows, debt financing and equipment leases.
The following table summarizes the capital expenditures by type for the years ended December 31, 2012 and 2011 (in millions):
(i) In 2011, KCSM entered into five loan agreements with General Electric Capital Corporation (“GE”) to finance approximately 88% of the purchase price of seventy-five locomotives. These locomotives were previously leased by KCSM under an operating lease.
Generally, the Company’s capital program consists of capital replacement. For 2013, internally generated cash flows are expected to fund cash capital expenditures, currently estimated at approximately $200.0 million.
KCSM’s minimum investments obligation
The Concession requires KCSM to make investments and undertake capital projects, including capital projects described in a business plan filed every five years with the SCT. The five-year plan was submitted in 2012 for the years 2013 - 2017. KCSM’s minimum investment obligations are as follows: $137.0 million, $143.0 million, $148.0 million, $154.0 million and $161.0 million for 2013, 2014, 2015, 2016 and 2017, respectively.
Property Statistics
The following table summarizes certain property statistics as of December 31:
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(i)
The increase in the miles of rail and cross ties installed in 2012 primarily reflects the increase in maintenance and capacity expansion activities.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
KCSM’s accounting and financial reporting policies are in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”). The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Management believes that the following accounting policies and estimates are critical to an understanding of KCSM’s historical and future performance. Management has discussed the development and selection of the following critical accounting estimates with the Audit Committee of KCS’s Board of Directors and the Audit Committee has reviewed the selection, application and disclosure of the Company’s critical accounting policies and estimates.
Capitalization, Depreciation and Amortization of Property and Equipment (including Concession Assets)
Due to the highly capital intensive nature of the railroad industry, capitalization and depreciation of property and equipment are substantial components of the Company’s consolidated financial statements. Net property and equipment, including concession assets, comprised approximately 87% of the Company’s total assets as of December 31, 2012, and related depreciation and amortization comprised approximately 15% of total operating expenses for the year ended December 31, 2012.
KCSM’s annual capital expenditures are primarily for capital replacement programs which are generally constructed by employees. KCSM capitalizes costs for self-constructed additions and improvements to property including direct labor and material, indirect overhead costs, and interest during long-term construction projects. Direct costs are charged to capital projects based on the work performed and the material used. Indirect overhead costs are allocated to capital projects as a standard percentage, which is evaluated annually, and applied to direct labor and material costs. Asset removal activities are performed in conjunction with replacement activities; therefore, removal costs are estimated based on a standard percentage of direct labor and indirect overhead costs related to capital replacement projects. For purchased assets, all costs necessary to make the asset ready for its intended use are capitalized. Expenditures that significantly increase asset values, productive capacity, efficiency, safety or extend useful lives are capitalized. Repair and maintenance costs are expensed as incurred.
Property and equipment are carried at cost and are depreciated primarily on the group method of depreciation, which the Company believes closely approximates a straight line basis over the estimated useful lives of the assets measured in years. Technology assets and leasehold improvements are depreciated using the straight line method over the lesser of the estimated useful lives of the assets or the lease term. Costs incurred by the Company to acquire the concession rights and related assets, as well as subsequent improvements to the concession assets, are capitalized and amortized using the group method of depreciation over the lesser of the current expected Concession term, including probable renewal of an additional 50-year term, or the estimated useful lives of the assets and rights. The Company’s ongoing evaluation of the useful lives of concession assets and rights considers the aggregation of the following facts and circumstances:
•
The Company’s executive management is dedicated to ensuring compliance with the various provisions of the Concession and to maintaining positive relationships with the SCT and other Mexican federal, state and municipal governmental authorities;
•
During the time since the Concession was granted, the relationships between KCSM and the various Mexican governmental authorities have matured and the guidelines for operating under the Concession have become more defined with experience;
•
There are no known supportable sanctions or compliance issues that would cause the SCT to revoke the Concession or prevent KCSM from renewing the Concession; and
•
KCSM operations are an integral part of the KCS operations strategy, and related investment analyses and operational decisions assume that the Company’s cross border rail business operates into perpetuity, and do not assume that Mexico operations terminate at the end of the current Concession term.
Based on the above factors, as of December 31, 2012, the Company continues to believe that it is probable that the Concession will be renewed for an additional 50-year term beyond the current term.
The group method of depreciation applies a composite rate to classes of similar assets rather than to individual assets. Composite depreciation rates are based upon the Company’s estimates of the expected average useful lives of assets as well as expected net salvage value at the end of their useful lives. In developing these estimates, the Company utilizes periodic depreciation studies performed by an independent engineering firm. Depreciation rate studies are performed at least every three years for equipment and at least every six years for road property (rail, ties, ballast, etc.). The depreciation studies take into account factors such as:
•
Statistical analysis of historical patterns of use and retirements of each asset class;
•
Evaluation of any expected changes in current operations and the outlook for the continued use of the assets;
•
Evaluation of technological advances and changes to maintenance practices; and
•
Historical and expected salvage to be received upon retirement.
The depreciation studies may also indicate that the recorded amount of accumulated depreciation is deficient or in excess of the amount indicated by the study. Any such deficiency or excess is amortized as a component of depreciation expense over the remaining useful lives of the affected asset class, as determined by the study. The Company also monitors these factors in non-study years to determine if adjustments should be made to depreciation rates. Any changes in depreciation rates are implemented prospectively.
During the year ended December 31, 2011, KCSM engaged an independent engineering firm to assist management in performing a depreciation study on its road property and equipment. The depreciation impacts of the study results were immaterial to 2011consolidated financial results.
Effective as of October 1, 2010, the Company reduced depreciation rates on certain locomotive assets based on reassessment of the adequacy of the accumulated depreciation provisions. This change in accounting estimate reduced annual depreciation expense by $13.0 million in 2011 and 2012.
Also under the group method of depreciation, the cost of railroad property and equipment (net of salvage or sales proceeds) retired or replaced in the normal course of business is charged to accumulated depreciation with no gain or loss recognized. Actual historical costs are retired when available, such as with equipment costs. The use of estimates in recording the retirement of certain roadway assets is necessary as it is impractical to track individual, homogeneous network-type assets. For these types of assets, historical costs are estimated by (1) deflating current costs using inflation indices published by the U.S. Bureau of Labor Statistics and (2) the estimated useful life of the assets as determined by the depreciation studies. The indices applied to the replacement value are selected because they closely correlate with the major costs of the items comprising the roadway assets. Because of the number of estimates inherent in the depreciation and retirement processes and because it is impossible to precisely estimate each of these variables until a group of assets is completely retired, the Company continually monitors the estimated useful lives of its assets and the accumulated depreciation associated with each asset group to ensure the depreciation rates are appropriate. Gains or losses on dispositions of land or non-group property and abnormal retirements of railroad property are recognized through income. A retirement of railroad property would be considered abnormal if the cause of the retirement is unusual in nature and its actual life is significantly shorter than what would be expected for that group based on the depreciation studies. An abnormal retirement could cause the Company to re-evaluate the estimated useful life of the impacted asset class. There were no significant gains or losses from abnormal retirements of property or equipment for any of the three years ended December 31, 2012.
Estimation of the average useful lives of assets and net salvage values require significant management judgment. Estimated average useful lives may vary over time due to changes in physical use, technology, asset strategies and other factors that could have an impact on the retirement experience of the asset classes. Accordingly, changes in the assets’ estimated useful lives could significantly impact future periods’ depreciation expense. Depreciation and amortization expense for the year ended December 31, 2012, was $91.3 million. If the weighted average useful lives of assets were changed by one year, annual depreciation and amortization expense would change approximately $3.1 million.
Long-lived assets are reviewed for impairment when events or circumstances indicate that the carrying amount of an asset may not be recoverable. If impairment indicators are present and the estimated future undiscounted cash flows are less than the carrying value of the long-lived assets, the carrying value would be reduced to the estimated fair value. Future cash flow estimates for an impairment review would be based on the lowest level of identifiable cash flows. During the years ended December 31, 2012 and 2011, management did not identify any indicators of impairment.
Income Taxes
Deferred income taxes represent a net asset or liability of the Company. For financial reporting purposes, management determines the current tax liability, as well as deferred tax assets and liabilities, in accordance with the liability method of accounting for income taxes. The provision for income taxes is the sum of income taxes both currently payable and deferred into the future. Currently payable income taxes represent the liability related to the income tax returns for the current year and anticipated tax payments resulting from income tax audits, while the deferred tax expense or benefit represents the change in the balance of net deferred tax assets or liabilities as reported on the balance sheet. The changes in deferred tax assets and liabilities are determined based upon the estimated timing of reversal of differences between the carrying amount of assets and liabilities for financial reporting purposes and the basis of assets and liabilities for tax purposes as measured using the currently enacted tax rates that will be in effect at the time these differences are expected to reverse. Additionally, management estimates whether taxable operating income in future periods will be sufficient to fully recognize any gross deferred tax assets.
The tax provision has additional complexities such as the impacts of exchange rate variations and inflation, both of which can have a significant impact on the effective income tax rate. Finally, the Company pays the greater of income tax or the Entrepreneurial Tax of Unique Rate (referred to by its Spanish acronym, IETU or Flat Tax) annually. The general principles and complexities of income tax accounting apply to the calculation of the statutorily required employee profit sharing expense and the related current and deferred liabilities. The employee profit sharing expense is recorded within compensation and benefits in the consolidated statements of comprehensive income. Effective May 1, 2012, KCSM’s employees were transferred to KCSM Servicios, and since the effective date KCSM had no legal obligation to pay statutory profit sharing.
Management believes that the assumptions and estimates related to the provision for income taxes are critical to the Company's results of operations. For the year ended December 31, 2012, income tax expense totaled $129.6 million. For every 1% change in the 2012 effective rate, income tax expense would have changed by approximately $3.2 million. For income taxes paid in Mexican pesos, the revaluation of U.S. denominated amounts (primarily debt) into Mexican pesos is taxed currently under Mexican tax law. If the exchange rate used at the end of 2012 had decreased from Ps.13.0 per U.S. dollar to Ps.12.0 per U.S. dollar, the effective income tax rate would have increased from 40.4% to 47.8% and income the tax expense would have increased by approximately $23.7 million. If the Mexican inflation rate used at the end of 2012 had increased from 4% to 5%, the effective income tax rate would have increased from 40.4% to 40.7%, and income tax expense would have increased by approximately $0.9 million.
OTHER MATTERS
Inflation. U.S. GAAP requires the use of historical cost, which does not reflect the effects of inflation on the replacement cost of property. Due to the capital intensive nature of the Company’s business, the replacement cost of its assets would be substantially higher than the amounts reported under the historical cost basis.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risks
KCSM utilizes various financial instruments that have certain inherent market risks. These instruments have not been entered into for trading purposes. The following information, together with Note 13 to the Consolidated Financial Statements in Item 8
Item 8.
Financial Statements and Supplementary Data
Index to Consolidated Financial Statements
Financial Statement Schedules:
All schedules are omitted because they are not applicable, are insignificant, or the required information is shown in the consolidated financial statements or notes thereto.
Management’s Report on Internal Control over Financial Reporting
The management of Kansas City Southern de México, S.A. de C.V. is responsible for establishing and maintaining adequate internal control over financial reporting as such term is defined in Exchange Act Rules 13a-15(f) and 15d-15(f). KCSM’s internal control over financial reporting was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements.
All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation.
Under the supervision and with the participation of the Company’s President and Executive Representative and the Chief Financial Officer, management conducted an evaluation of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2012, based on the framework established by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control - Integrated Framework (commonly referred to as the COSO framework). Based on its evaluation, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2012, based on the criteria outlined in the COSO framework.
This annual report does not include an attestation report of the Company’s independent registered public accounting firm regarding internal control over financial reporting pursuant to the rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in the annual report on Form 10-K.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Kansas City Southern de México, S.A. de C.V.:
We have audited the accompanying consolidated balance sheets of Kansas City Southern de México, S.A. de C.V. and subsidiaries (the Company) as of December 31, 2012 and 2011, and the related consolidated statements of comprehensive income, changes in stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Kansas City Southern de México, S.A. de C.V. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.
As discussed in note 2 to the consolidated financial statements, effective January 1, 2012, the Company elected to present comprehensive income and its components in a single continuous statement.
/s/ KPMG LLP
Kansas City, Missouri
February 4, 2013
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Consolidated Statements of Comprehensive Income
Years Ended December 31,
See accompanying notes to consolidated financial statements.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Consolidated Balance Sheets
December 31,
See accompanying notes to consolidated financial statements.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Consolidated Statements of Cash Flows
Years Ended December 31,
See accompanying notes to consolidated financial statements.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Consolidated Statements of Changes in Stockholders’ Equity
See accompanying notes to consolidated financial statements.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements
Note 1. Description of the Business
Kansas City Southern de México, S.A. de C.V. (“KCSM” or the “Company”) operates the primary commercial corridor of the Mexican railroad system, which allows it to participate significantly in the growing freight traffic between Mexico, the U.S. and Canada. KCSM’s rail lines consist of approximately 3,200 route miles. In addition, KCSM has trackage rights permitting it to run its trains over 700 miles of track of other Mexican railroad operators. KCSM is a wholly-owned subsidiary of Kansas City Southern (“KCS”). KCS’s principal U.S. subsidiary, The Kansas City Southern Railway Company (“KCSR”), is a U.S. Class I railroad. The rail networks of KCSR; The Texas Mexican Railway Company (“Tex-Mex”), also a KCS wholly-owned subsidiary; and KCSM together comprise approximately 6,300 route miles extending from the midwest and southeast portions of the United States into Mexico.
Arrendadora KCSM, S. de R.L. de C.V. (“Arrendadora KCSM”), a wholly-owned subsidiary, is a sociedad de responsabilidad limitada de capital variable, or S. de R.L. de C.V. (limited liability corporation). Arrendadora KCSM was incorporated on September 27, 2002, under the laws of Mexico and its only operation is the leasing of railroad equipment.
KCSM Holdings LLC (“KCSM Holdings”) was formed on December 11, 2006, as a limited liability company under the laws of the state of Delaware. KCSM owns one hundred percent of the interest of KCSM Holdings.
Mexrail, Inc. (“Mexrail”) owns 100% of Tex-Mex. Until June 2010, KCSM owned 49% of the outstanding capital stock of Mexrail and KCS owned the remaining 51% of Mexrail’s outstanding capital stock. For the year ended December 31, 2010, KCSM recognized its 49% interest under the equity method of accounting and included in its income statement $3.4 million of income.
On June 10, 2010, KCSM sold its 49% ownership interest in Mexrail, Inc. to KCS for $41.0 million based upon an independent valuation, which resulted in a gain of $0.7 million. The sale resulted in a $4.3 million tax benefit due to excess tax over book basis in the investment.
Ferrocarril y Terminal del Valle de México, S.A. de C.V. (Mexico Valley Railway and Terminal or “FTVM”) was incorporated as a sociedad anónima de capital variable (variable capital corporation) under the laws of Mexico. FTVM provides railroad services as well as ancillary services, including those related to interconnection, switching and haulage services in the greater Mexico City area. KCSM holds 25% of the capital stock of FTVM. The other shareholders of FTVM, each holding a 25% interest, are Ferrocarril Méxicano, S.A. de C.V. or “Ferromex,” Ferrosur, S.A. de C.V. or “Ferrosur” and the Mexican government.
For the years ended December 31, 2012, 2011 and 2010, KCSM recognized its 25% interest under the equity method of accounting and has included in its income statement $3.2 million, $2.8 million and $3.2 million of income, respectively, attributable to its interest in FTVM. In 2012, 2011 and 2010, KCSM received cash dividends of $2.3 million, $2.3 million and $1.5 million, respectively, from FTVM.
Highstar Harbor Holdings México, S. de R.L. de C.V., (“HHH Mexico”) was formed as a sociedad de responsabilidad limitada de capital variable, or S. de R.L. de C.V. (limited liability corporation). KCSM acquired HHH Mexico on March 3, 2010. KCSM owns 99.99% of the capital stock of HHH Mexico and the remaining 0.01% is owned by Nafta Rail, S.A de C.V. (“Nafta Rail”). Nafta Rail is a wholly-owned subsidiary of KCS. HHH Mexico, through its subsidiaries, operates an intermodal facility in Toluca, State of Mexico.
The Concession. KCSM holds a concession from the Mexican government (the “Concession”) until June 2047 (exclusive through 2027, subject to certain trackage and haulage rights granted to other concessionaires), which is renewable under certain conditions for an additional period of up to 50 years. The Concession is to provide freight transportation services over rail lines which are a primary commercial corridor of the Mexican railroad system. These lines include the shortest, most direct rail passageway between Mexico City and Laredo, Texas and serve most of Mexico’s principal industrial cities and three of its major shipping ports. KCSM has the right to use, but does not own, all track and buildings that are necessary for the rail lines’ operation. KCSM is obligated to maintain the right of way, track structure, buildings and related maintenance facilities to the operational standards specified in the Concession agreement and to return the assets in that condition at the end of the Concession period. KCSM was required to pay the Mexican government a concession duty equal to 0.5% of gross revenues during the first 15 years of the Concession period, and on June 24, 2012, KCSM began paying 1.25% of gross revenues, which is effective for the remaining years of the Concession period.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Under the Concession and Mexican law, the Company may freely set rates unless the Mexican government determines that there is no effective competition in Mexico’s rail industry. KCSM is required to register its rates with the Mexican government and to provide railroad services to all users on a fair and non-discriminatory basis and in accordance with efficiency and safety standards approved periodically by the Mexican government. In the event that rates charged are higher than the registered rates, KCSM must reimburse customers with interest, and risk the revocation of the Concession.
Mexican Railroad Services Law and regulations and the Concession establish several circumstances under which the Concession will terminate: revocation by the Mexican government, statutory appropriation, or KCSM’s voluntary surrender of its rights or liquidation or bankruptcy. The Concession requires the undertaking of capital projects, including those described in a business plan filed every five years with the Mexican government. The five-year plan was submitted in the fourth quarter of 2012 for the years 2013-2017 in which KCSM committed to certain minimum investment and capital improvement goals, which may be waived by the Mexican government upon application for relief for good cause. The Mexican government could also revoke KCSM’s exclusivity after 2027 if it determines that there is insufficient competition.
The Concession is subject to early termination or revocation under certain circumstances. In the event that the Concession is revoked by the Mexican government, KCSM will receive no compensation. Rail lines and all other fixtures covered by the Concession, as well as all improvements made by KCSM or third parties, will revert to the Mexican government. All other property not covered by the Concession, including all locomotives and railcars otherwise acquired, will remain KCSM’s property. In the event of early termination, or total or partial revocation of the Concession, the Mexican government would have the right to cause the Company to lease all service-related to assets to it for a term of at least one year, automatically renewable for additional one-year terms up to five years. The amount of the rent would be determined by experts appointed by KCSM and the Mexican government. The Mexican government must exercise this right within four months after early termination or revocation of the Concession. In addition, the Mexican government would have a right of first refusal with respect to certain transfers by KCSM of railroad equipment within 90 days after any revocation of the Concession. The Mexican government may also temporarily seize the rail lines and assets used in operating the rail lines in the event of a natural disaster, war, significant public disturbances or imminent danger to the domestic peace or economy for the duration of any of the foregoing events; provided, however, that Mexican law requires that the Mexican government pay KCSM compensation equal to damages caused and losses suffered if it effects a statutory appropriation for reasons of the public interest. These payments may not be sufficient to compensate the Company for its losses and may not be made timely.
Organizational Restructuring. Effective May 1, 2012, KCS completed an organizational restructuring whereby employees of KCSM became employees of KCSM Servicios, S.A. de C.V. (“KCSM Servicios”), a wholly-owned subsidiary of KCS.
Employees and Labor Relations. KCSM Servicios provides employee services to KCSM, and KCSM pays KCSM Servicios market-based rates for these services. KCSM Servicios’ union employees are covered by one labor agreement, which was signed on June 23, 1997, between KCSM and the Sindicato de Trabajadores Ferrocarrileros de la República Mexicana (“Mexican Railroad Union”), for a term of 50 years, for the purpose of regulating the relationship between the parties. As of December 31, 2012, approximately 80% of KCSM Servicios employees are covered by this labor agreement. The compensation terms under this labor agreement are subject to renegotiation on an annual basis, and all other benefits are subject to negotiation every two years. As a result of the labor agreement signed on April 19, 2012, compensation terms for the period from July 1, 2012, through June 30, 2013, were finalized. The union labor negotiation with the Mexican Railroad Union has not historically resulted in any strike, boycott or other disruption in KCSM's business operations.
Note 2. Significant Accounting Policies
Principles of Consolidation. The accompanying consolidated financial statements are presented using the accrual basis of accounting and include the Company and its majority-owned subsidiaries. All significant intercompany accounts and transactions have been eliminated. Certain prior year amounts have been reclassified to conform to the current year presentation.
The equity method of accounting is used for all entities in which the Company or its subsidiaries have significant influence, but not a controlling interest. The Company evaluates less-than-majority-owned investments for consolidation pursuant to consolidation and variable interest entity guidance. The Company does not have any less-than-majority-owned investments requiring consolidation.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Basis of Presentation. As a result of the organizational restructuring, KCSM Servicios provides employee services to KCSM, and KCSM pays KCSM Servicios market-based rates for these services. This market-based rate is determined by applying a percentage mark-up to amounts paid by KCSM Servicios to its employees and vendors. For comparative purposes, amounts paid to KCSM Servicios are classified according to the nature of the services provided to KCSM and the percentage mark-up portion of payments to KCSM Servicios is included within materials and other expense.
Use of Estimates. The accounting and financial reporting policies of the Company conform to accounting principles generally accepted in the United States of America (“U.S. GAAP”). The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Significant items subject to such estimates and assumptions include those related to the recoverability and useful lives of assets, litigation provisions and income taxes. Changes in facts and circumstances may result in revised estimates and actual results could differ from those estimates.
Segments. KCSM is organized as a single business segment (railway) and currently operates within a single geographical area (Mexico).
Revenue Recognition. The Company recognizes freight revenue based upon the percentage of completion of a commodity movement as a shipment moves from origin to destination, with the related expense recognized as incurred. Other revenues, in general, are recognized when the product is shipped, as services are performed or contractual obligations are fulfilled.
Foreign Exchange Gain (Loss). For financial reporting purposes, KCSM and its subsidiaries maintain records in U.S. dollars, which is the functional currency. The dollar is the currency that reflects the economic substance of the underlying events and circumstances relevant to the entity. Monetary assets and liabilities denominated in pesos are remeasured into dollars using current exchange rates. The difference between the exchange rate on the date of the transaction and the exchange rate on the settlement date, or balance sheet date if not settled, is included in the income statement as foreign exchange gain or loss.
Cash Equivalents. Short-term liquid investments with an initial maturity of three months or less are classified as cash and cash equivalents.
Accounts Receivable, net. Accounts receivable are net of an allowance for uncollectible accounts as determined by historical experience and adjusted for economic uncertainties or known trends. Accounts are charged to the allowance when a customer enters bankruptcy, when an account has been transferred to a collection agent or submitted for legal action or when a customer is significantly past due and all available means of collection have been exhausted. At December 31, 2012 and 2011, the allowance for doubtful accounts was $0.2 million and $0.3 million, respectively. Bad debt expense was $0.1 million and$0.4 million for the years ended December 31, 2012 and 2011, respectively. For the year ended December 31, 2010, accounts receivable allowance recovery was $0.3 million.
Materials and Supplies. Materials and supplies consisting of diesel fuel, items to be used in the maintenance of rolling stock and items to be used in the maintenance or construction of road property are valued at average cost.
Derivative Instruments. Derivatives are measured at fair value and recorded on the balance sheet as either assets or liabilities. Changes in the fair value of derivatives are recorded either through current earnings or as other comprehensive income, depending on hedge designation. Gains and losses on derivative instruments classified as cash flow hedges are reported in other comprehensive income and are reclassified into earnings in the periods in which earnings are impacted by the variability of the cash flow of the hedged item. The ineffective portion of all hedge transactions is recognized in current period earnings.
Property and Equipment (including Concession Assets). KCSM capitalizes costs for self-constructed additions and improvements to property including direct labor and material, indirect overhead costs, and interest during long-term construction projects. Direct costs are charged to capital projects based on the work performed and the material used. Indirect overhead costs are allocated to capital projects as a standard percentage, which is evaluated annually, and applied to direct labor and material costs. Asset removal activities are performed in conjunction with replacement activities; therefore, removal costs are estimated based on a standard percentage of direct labor and indirect overhead costs related to capital replacement projects. For purchased assets, all costs necessary to make the asset ready for its intended use are capitalized. Expenditures that significantly increase asset values, productive capacity, efficiency, safety or extend useful lives are capitalized. Repair and maintenance costs are expensed as incurred.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Property and equipment are carried at cost and are depreciated primarily on the group method of depreciation, which the Company believes closely approximates a straight line basis over the estimated useful lives of the assets measured in years. Technology assets and leasehold improvements are depreciated using the straight line method over the lesser of the estimated useful lives of the assets or the lease term. Costs incurred by the Company to acquire the concession rights and related assets, as well as subsequent improvements to the concession assets, are capitalized and amortized using the group method of depreciation over the lesser of the current expected Concession term, including probable renewal of an additional 50-year term, or the estimated useful lives of the assets and rights.
The group method of depreciation applies a composite rate to classes of similar assets rather than to individual assets. Composite depreciation rates are based upon the Company’s estimates of the expected average useful lives of assets as well as expected net salvage value at the end of their useful lives. In developing these estimates, the Company utilizes periodic depreciation studies performed by an independent engineering firm. Depreciation rate studies are performed at least every three years for equipment and at least every six years for road property (rail, ties, ballast, etc.). The depreciation studies take into account factors such as:
•
Statistical analysis of historical patterns of use and retirements of each asset class;
•
Evaluation of any expected changes in current operations and the outlook for the continued use of the assets;
•
Evaluation of technological advances and changes to maintenance practices; and
•
Historical and expected salvage to be received upon retirement.
The depreciation studies may also indicate that the recorded amount of accumulated depreciation is deficient or in excess of the amount indicated by the study. Any such deficiency or excess is amortized as a component of depreciation expense over the remaining useful lives of the affected asset class, as determined by the study. The Company also monitors these factors in non-study years to determine if adjustments should be made to depreciation rates. Any changes in depreciation rates are implemented prospectively.
During the year ended December 31, 2011, KCSM engaged an independent engineering firm to assist management in performing a depreciation study on its road property and equipment. The depreciation impacts of the study results were immaterial to 2011 financial results.
Effective as of October 1, 2010, the Company reduced depreciation rates on certain locomotive assets based on reassessment of the adequacy of the accumulated depreciation provisions. This change in accounting estimate reduced annual depreciation expense by $13.0 million in 2011 and 2012.
Also under the group method of depreciation, the cost of railroad property and equipment (net of salvage or sales proceeds) retired or replaced in the normal course of business is charged to accumulated depreciation with no gain or loss recognized. Actual historical costs are retired when available, such as with equipment costs. The use of estimates in recording the retirement of certain roadway assets is necessary as it is impractical to track individual, homogeneous network-type assets. For these types of assets, historical costs are estimated by (1) deflating current costs using inflation indices published by the U.S. Bureau of Labor Statistics and (2) the estimated useful life of the assets as determined by the depreciation studies. The indices applied to the replacement value are selected because they closely correlate with the major costs of the items comprising the roadway assets. Because of the number of estimates inherent in the depreciation and retirement processes and because it is impossible to precisely estimate each of these variables until a group of assets is completely retired, the Company continually monitors the estimated useful lives of its assets and the accumulated depreciation associated with each asset group to ensure the depreciation rates are appropriate. Gains or losses on dispositions of land or non-group property and abnormal retirements of railroad property are recognized through income. A retirement of railroad property would be considered abnormal if the cause of the retirement is unusual in nature and its actual life is significantly shorter than what would be expected for that group based on the depreciation studies. An abnormal retirement could cause the Company to re-evaluate the estimated useful life of the impacted asset class.
Long-lived assets are reviewed for impairment when events or circumstances indicate that the carrying amount of an asset may not be recoverable. If impairment indicators are present and the estimated future undiscounted cash flows are less than the carrying value of the long-lived assets, the carrying value would be reduced to the estimated fair value. Future cash flow estimates for an impairment review would be based on the lowest level of identifiable cash flows. During the years ended December 31, 2012 and 2011, management did not identify any indicators of impairment.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Goodwill. Goodwill represents the excess of the purchase price over the fair value of the net identifiable assets acquired in a business combination. As of December 31, 2012 and 2011, the goodwill balance was $2.6 million, which is included in other assets in the consolidated balance sheet. Goodwill is not amortized, but is reviewed at least annually, or more frequently as indicators warrant, for impairment. An impairment loss would be recognized to the extent that the carrying amount exceeds the assets’ fair value. The Company performed its annual impairment review for goodwill as of November 30, 2012 and 2011, and concluded there was no impairment in 2012 or 2011.
Fair Value of Financial Instruments. The Company’s short-term financial instruments include cash and cash equivalents, accounts receivable and accounts payable. The carrying value of the short-term financial instruments approximates fair value.
The fair value of the Company’s debt, including related company debt, is estimated using quoted market prices when available, which is classified as Level 1 in the fair value hierarchy. When quoted market prices are not available, fair value is estimated based on current market interest rates for debt with similar maturities and credit quality, which is classified as Level 2. The fair value of the Company’s debt was $1,240.9 million and $1,297.1 million at December 31, 2012 and 2011, respectively. The carrying value was $1,135.1 million and $1,219.5 million at December 31, 2012 and 2011, respectively. If the Company's debt was measured at fair value, the individual debt instruments would have been classified as either Level 1 or Level 2 in the fair value hierarchy.
Postemployment Benefits. Mexican law requires that the Company provide certain postemployment benefits to its Mexican union and non-union employees. These plans provide statutorily calculated benefits which are payable upon retirement, death, disability, and voluntary or involuntary termination to employees who meet applicable service requirements. Actuaries assist the Company in measuring the Company’s benefit obligation and the cost based upon the current plan provisions, employee demographics and assumptions about financial and demographic factors affecting the probability, timing and amount of expected future benefit payments. Significant assumptions include the discount rate, turnover and rate of increase in compensation levels. Actuarial gains and losses determined at the measurement date (typically December 31) are recognized immediately in the consolidated statements of comprehensive income. Effective May 1, 2012, KCS completed an organizational restructuring whereby employees of KCSM became employees of KCSM Servicios. Accordingly, KCSM's obligation to pay postemployment benefits terminated and the related postemployment benefit obligation incurred prior to the effective date was transferred to KCSM Servicios.
Employees’ Statutory Profit Sharing. Mexican employees are statutorily entitled to receive statutory profit sharing. This payment is based on an employer’s net profit based on accounting principles as prescribed in Mexican law, rather than net profit based on U.S. GAAP. Effective May 1, 2012, KCS completed the organizational restructuring whereby employees of KCSM became employees of KCSM Servicios. Accordingly, KCSM's employees were transferred to KCSM Servicios and KCSM's obligation to pay statutory profit sharing terminated as of the effective date.
Income Taxes. Deferred income tax effects of transactions reported in different periods for financial reporting and income tax return purposes are recorded under the liability method of accounting for income taxes. This method gives consideration to the future tax consequences of the deferred income tax items and immediately recognizes changes in income tax laws in the year of enactment.
The Company has recognized a deferred tax asset, net of a valuation allowance, for net operating loss carryovers. The Company projects sufficient future taxable income to realize the deferred tax asset recorded less the valuation allowance. These projections take into consideration assumptions about inflation rates, currency fluctuations, future income and future capital expenditures. If assumptions or actual conditions change, the deferred tax asset, net of the valuation allowance, will be adjusted to properly reflect the expected tax benefit.
New Accounting Pronouncements
Effective January 1, 2012, the Company adopted, on a retrospective basis, the new accounting guidance on the presentation of comprehensive income. As a result of the adoption, the Company reports net income and other comprehensive income in a single statement.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Note 3. Elimination of Deferred Statutory Profit Sharing Liability, Net
During the second quarter of 2012, KCS completed an organizational restructuring whereby employees of KCSM became employees of KCSM Servicios, a wholly-owned subsidiary of KCS. KCSM Servicios provides employee services to KCSM, and KCSM pays KCSM Servicios market-based rates for these services. The effective date of this organizational restructuring was May 1, 2012.
Mexican employees are entitled to receive statutory profit sharing. The related cash payment to employees is based on an employer’s net profit determined under accounting principles prescribed in Mexican law, rather than its net profit determined under U.S. GAAP. U.S. GAAP requires the recording of deferred liabilities or assets for financial reporting purposes on the differences between the amounts determined under the two different accounting principles.
As a result of the organizational restructuring, KCSM’s obligation to pay statutory profit sharing terminated on the effective date. Accordingly, in the second quarter of 2012, KCSM recognized a $43.0 million net reduction to operating expense. This reduction includes the elimination of $47.8 million of the deferred statutory profit sharing liability, net of $4.8 million of transaction costs. KCSM Servicios became obligated to pay statutory profit sharing to its employees beginning on the effective date of the organizational restructuring.
Note 4. Insurance Recoveries
In the third quarter of 2011, the Company settled its insurance claim related to hurricane Alex, which struck in 2010 and resulted in extensive damage to KCSM’s track and bridge infrastructures, caused multiple track-related incidents and significantly disrupted the Company’s rail service. As a result of this settlement, the Company recognized a gain on insurance recoveries of $14.8 million in the third quarter of 2011. This gain primarily represented the recovery of lost profits and the replacement value of property in excess of its carrying value, net of the self-insured retentions.
Note 5. Property and Equipment (including Concession Assets)
The following tables list the major categories of property and equipment, including concession assets, as well as the weighted-average composite depreciation rate for each category (in millions, except percentages):
____________________
(a)
Other includes signals, buildings and other road assets.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
______________________
(a)
Other includes signals, buildings and other road assets.
Concession assets, net of accumulated amortization of $413.3 million and $347.1 million, totaled $1,916.5 million and $1,855.1 million at December 31, 2012 and 2011, respectively.
Depreciation and amortization of property and equipment (including concession assets) totaled $91.3 million, $86.8 million and $94.0 million for 2012, 2011 and 2010, respectively.
Note 6. Other Balance Sheet Captions
Other Current Assets. Other current assets included the following items at December 31 (in millions):
Accounts Payable and Accrued Liabilities. Accounts payable and accrued liabilities included the following items at December 31 (in millions):
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Note 7. Long-Term Debt
Long-term debt at December 31 (in millions):
Debt
Revolving Credit Facility. On August 30, 2010, KCSM entered into a secured credit agreement (the “2010 Credit Agreement”) with various lenders and other institutions which provided KCSM with a three-year $100.0 million revolving credit facility consisting of (i) a revolving facility in an amount up to $100.0 million (the “2010 Revolving Facility”) and, (ii) a letter of credit and a swing line facility in an amount up to $10.0 million each.
On September 30, 2011, KCSM entered into an amended and restated credit agreement (the “2011 Credit Agreement”) with various financial institutions. The 2011 Credit Agreement increased the revolving credit facility to $200.0 million and extended the maturity to September 30, 2016. The 2011 Credit Agreement included (i) a revolving credit facility up to $200.0 million (the “Revolving Facility”), (ii) a letter of credit facility up to $15.0 million (the “Letter of Credit Facility”), and (iii) a swing line facility up to $15.0 million (the “Swing Line Facility”). The Letter of Credit Facility and the Swing Line Facility each constitute usage under the Revolving Facility.
On November 29, 2012, KCSM entered into an amended and restated credit agreement (the “2012 Credit Agreement”) with various financial institutions, which amended and restated the 2011 Credit Agreement and eliminated or modified a number of restrictive covenants in KCSM's facility in order to achieve consistency between KCSM and firms with investment grade credit ratings. The amendment also included a "fall-away collateral" provision whereby KCSM's facility will convert from secured to unsecured obligations if investment grade senior unsecured debt ratings are assigned by at least two of the three primary rating agencies. In the event that KCSM's senior unsecured debt ratings were subsequently to fall below investment grade at all three primary rating agencies, collateral would be re-pledged and the facility would revert to a secured obligation. The amendment also incorporates a change in the pricing grid in the event that KCSM achieves a senior unsecured debt rating of BBB/Baa2 or higher by at least two of the three primary rating agencies. In that event, the floating interest rates paid by KCSM on the 2012 Credit Agreement would thereafter be determined by KCSM's senior unsecured credit rating rather than by KCSM's leverage ratio as is the case currently. Depending on KCSM's credit rating during the life of the 2012 Credit Agreement, the margin KCSM would pay above the London Interbank Offered Rate (“LIBOR”) at any point would be equal to or lower than the currently applicable margin of 1.75%. In addition to the amendment, KCSM extended the maturity of the Revolving Facility to November 15, 2017.
The 2012 Credit Agreement is currently secured by the accounts receivable and certain locomotives of KCSM and certain of its subsidiaries. In addition, KCSM and certain of its subsidiaries agreed to subordinate payment of certain intercompany debt, certain KCSM subsidiaries guaranteed repayment of the amounts due under the 2012 Credit Agreement (up to the amount permitted by KCSM’s outstanding indentures) and certain equity interests as defined in the 2012 Credit Agreement were pledged to secure obligations under the 2012 Credit Agreement.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
The 2012 Credit Agreement contains certain representations and warranties that are customary for credit agreements of this type. The 2012 Credit Agreement also contains affirmative and negative covenants that are customary for credit agreements of this type, including financial maintenance covenants related to a leverage ratio and an interest coverage ratio as defined in the 2012 Credit Agreement. Similarly, events of default under the 2012 Credit Agreement include, but are not limited to, certain payment defaults; breach of any representation or warranty; non-performance of covenants and obligations; default on other indebtedness; certain judgments rendered; restrictions or requirements limiting the availability or the transfer of foreign exchange; a change in control; bankruptcy or insolvency of KCSM and certain subsidiaries and obligors; an impairment of security; the failure of subordination; certain actions by a governmental authority; failure to obtain certain consents; and termination of the concession title. The occurrence of an event of default could result in the acceleration of the repayment of any outstanding principal balance of the Revolving Facility.
As of December 31, 2012 and 2011, KCSM had no outstanding amount under the Revolving Facility.
12½% Senior Notes. On March 30, 2009, KCSM issued $200.0 million principal amount of the 12½% senior unsecured notes due April 1, 2016 (the “12½% Senior Notes”), which bear interest semiannually at a fixed annual rate of 12½%. The 12½% Senior Notes were issued at a discount to par value, resulting in an $11.0 million discount and a yield to maturity of 13¾%. KCSM used a portion of the net proceeds from the offering to repay all amounts outstanding under a credit agreement entered into on June 14, 2007. The 12½% Senior Notes are redeemable at KCSM’s option in whole or in part on and after April 1, 2013, at the following redemption prices (expressed as percentages of principal amount) plus any accrued and unpaid interest: 2013 - 106.250%, 2014 - 103.125% and 2015 - 100.000%. In addition, the notes are redeemable, in whole but not in part, at KCSM’s option at their principal amount, plus any accrued and unpaid interest, in the event of certain changes in the Mexican withholding tax rate.
On June 4, 2010, KCSM redeemed $70.0 million principal amount of the 12½% Senior Notes pursuant to a provision which allowed KCSM to redeem up to 35.0% of the 12½% Senior Notes any time prior to April 1, 2012, at par value plus coupon from the proceeds of any sale of capital stock in KCSM or KCS. This followed KCS’s offering of 5.8 million shares of common stock for net proceeds of $214.9 million in May 2010 and a subsequent $95.0 million capital contribution from KCS to the Company. On November 2, 2010, pursuant to an offer to purchase, KCSM commenced a cash tender offer for its 12½% Senior Notes. On December 20, 2010, KCSM purchased $31.9 million principal amount of the tendered 12½% Senior Notes in accordance with the terms and conditions of the tender offer set forth in the offer to purchase using the proceeds received from the issuance of $185.0 million principal amount of the 65/8% senior unsecured notes due December 15, 2020 (the “65/8% Senior Notes”).
8.0% Senior Notes. On January 22, 2010, KCSM issued $300.0 million principal amount of 8.0% senior unsecured notes due February 1, 2018 (the “8.0% Senior Notes”), which bear interest semiannually at a fixed annual rate of 8.0%. The 8.0% Senior Notes were issued at a discount to par value, resulting in a $4.3 million discount and a yield to maturity of 8¼%. KCSM used the net proceeds from the issuance of the 8.0% Senior Notes and available cash to purchase $290.0 million principal amount of the 93/8% senior unsecured notes due May 1, 2012 (the “93/8% Senior Notes”) tendered under an offer to purchase and pay all fees and expenses incurred in connection with the 8.0% Senior Notes offering and the tender offer. The 8.0% Senior Notes are redeemable at KCSM’s option, in whole or in part, on and after February 1, 2014, at the following redemption prices (expressed as percentages of principal amount) plus any accrued and unpaid interest: 2014 - 104.000%, 2015 - 102.000%, 2016 and thereafter - 100.000%. In addition, KCSM may redeem up to 35% of the 8.0% Senior Notes any time prior to February 1, 2013, at par value plus coupon from the proceeds of the sale of capital stock in KCSM or KCS. In addition, the notes are redeemable, in whole but not in part, at KCSM’s option at their principal amount, plus any accrued and unpaid interest, in the event of certain changes in the Mexican withholding tax rate.
65/8% Senior Notes. On December 20, 2010, KCSM issued the 65/8% Senior Notes, which bear interest semiannually at a fixed annual rate of 65/8%. KCSM used the net proceeds from the issuance of the 65/8% Senior Notes and available cash to purchase $142.6 million principal amount of the 75/8% senior unsecured notes due December 1, 2013 (the “75/8% Senior Notes”) and $31.9 million principal amount of the 12½% Senior Notes tendered under an offer to purchase and pay all fees and expenses incurred in connection with the 65/8% Senior Notes offering and the tender offers. The 65/8% Senior Notes are redeemable at KCSM’s option, in whole or in part prior to December 15, 2015, by paying the greater of either 101% of the principal amount or the principal amount plus a “make whole” premium and in whole or in part on or after December 15, 2015, at the following redemption prices (expressed as percentages of principal amount) plus any accrued and unpaid interest: 2015- 103.313%, 2016 - 102.208%, 2017 - 101.104%, 2018 and thereafter -100.000%. In addition, KCSM may redeem up to 35% of the 65/8% Senior Notes at a redemption price equal to 106.625% any time prior to December 15, 2013, at par value plus coupon from the proceeds of the sale of capital stock in KCSM or KCS. In addition, the notes are redeemable, in whole but not in part, at KCSM’s option at their principal amount, plus any accrued and unpaid interest, in the event of certain changes in the Mexican withholding tax rate.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
61/8% Senior Notes. On May 20, 2011, KCSM issued $200.0 million principal amount of the 61/8% senior unsecured notes due June 15, 2021 (the “61/8% Senior Notes”) at par, which bear interest semiannually at a fixed annual rate of 61/8%. The Company used the proceeds from the issuance of the 61/8% Senior Notes and available cash to purchase and redeem the outstanding $165.0 million principal amount of 73/8% senior unsecured notes due June 1, 2014 and the remaining $32.4 million principal amount of the 75/8% Senior Notes and pay all fees and expenses incurred in connection with the 61/8% Senior Notes offering and the tender offers. The 61/8% Senior Notes are redeemable at KCSM’s option, in whole or in part prior to June 15, 2016, by paying the greater of either 101% of the principal amount or the principal amount plus a “make whole” premium and in whole or in part on or after June 15, 2016, at the following redemption prices (expressed as percentages of principal amount) if redeemed during the 12-month period commencing on June 15 of the following years, plus any accrued and unpaid interest to the date of redemption: 2016 - 103.063%, 2017 - 102.042%, 2018 - 101.021%, 2019 and thereafter -100.000%. In addition, the Company may redeem up to 35.0% of the 61/8% Senior Notes at a redemption price equal to 106.125% any time prior to June 15, 2014, from the proceeds of the sale of KCSM’s capital stock or the capital stock of KCS. In addition, the notes are redeemable, in whole but not in part, at KCSM’s option at their principal amount, plus any accrued and unpaid interest, in the event of certain changes in the Mexican withholding tax rate.
All of KCSM’s senior notes described above are denominated in dollars; are unsecured, unsubordinated obligations; rank pari passu in right of payment with KCSM’s existing and future unsecured, unsubordinated obligations and are senior in right of payment to KCSM’s future subordinated indebtedness. In addition, the senior notes include certain covenants which are customary for these types of debt instruments issued by borrowers with similar credit ratings and restrict or prohibit certain actions. Certain of these covenants no longer apply if the notes are assigned an investment grade rating by both Moody’s Investors Service and Standard & Poor’s Rating Services.
Locomotive Financing
5.737% Financing Agreement. On February 26, 2008, KCSM entered into a financing agreement with Export Development Canada (“EDC”) for an aggregate principal amount of $72.8 million. KCSM used the proceeds to finance 85.0% of the purchase price of forty new SD70ACe locomotives purchased by KCSM in late 2007 and early 2008. KCSM granted EDC a security interest in the locomotives to secure the loan. The financing agreement requires KCSM to make thirty equal semi-annual principal payments of approximately $2.4 million plus interest at an annual rate of 5.737%, with the final payment due and payable on February 28, 2023.
6.195% Financing Agreement. On September 24, 2008, KCSM entered into a financing agreement with DVB Bank AG (“DVB”) for an aggregate principal amount of $52.2 million. KCSM used the proceeds to finance approximately 80% of the purchase price of twenty-nine ES44AC locomotives purchased by KCSM in June 2008. KCSM granted DVB a security interest in the locomotives to secure the loan. The financing agreement requires KCSM to make sixty equal quarterly principal payments plus interest at an annual rate of 6.195%, with the final payment due and payable on September 29, 2023.
9.310% Loan Agreements. On September 1, 2011, KCSM, as borrower, entered into five Loan Agreements (each a “Loan Agreement”, and collectively, the “Loan Agreements”) with General Electric Capital Corporation, as lender (“GE”), each with a principal amount of approximately $18.2 million. KCSM used the loan proceeds to finance approximately 88% of the purchase price of seventy-five GE AC4400 CW locomotives (the “Locomotives”) purchased by KCSM from GE on September 1, 2011. The Locomotives were previously leased by KCSM from GE pursuant to a Lease Agreement dated April 30, 1998. The Lease Agreement, which had been accounted for as an operating lease, was terminated with the purchase of the Locomotives by KCSM. To secure the loans from GE, KCSM transferred legal ownership of the Locomotives to five irrevocable trusts established by KCSM to which GE is the primary beneficiary and KCSM has a right of reversion upon satisfaction of the obligations of the Loan Agreements.
Each Loan Agreement requires KCSM to make thirty-eight quarterly principal payments plus interest at an annual rate of 9.31%, which approximates the implicit interest rate in the Lease Agreement. KCSM generated certain tax benefits as a result of purchasing the locomotives. The first payments were due and payable on September 15, 2011, and the final payments are due and payable on December 15, 2020.
KCSM’s locomotive financing agreements contain representations, warranties and covenants typical of such equipment loan agreements. Events of default in the financing agreements include, but are not limited to, certain payment defaults, certain bankruptcy and liquidation proceedings and the failure to perform any covenants or agreements contained in the financing agreements. Any event of default could trigger acceleration of KCSM’s payment obligations under the terms of the financing agreements.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Debt Covenants Compliance
The Company was in compliance with all of its debt covenants as of December 31, 2012.
Leases and Debt Maturities
The Company leases transportation equipment, as well as office and other operating facilities under various capital and operating leases. Rental expenses under operating leases were $38.3 million, $46.6 million and $53.7 million for the years ended December 31, 2012, 2011 and 2010, respectively. Operating leases that contain scheduled rent adjustments are recognized on a straight-line basis over the term of the lease. Contingent rentals and sublease rentals were not significant. Minimum annual payments and present value thereof under existing capital leases, other debt maturities and minimum annual rental commitments under non-cancelable operating leases are shown below (in millions):
In the normal course of business, the Company enters into long-term contractual requirements for future goods and services needed for the operations of the business. Such commitments are not in excess of expected requirements and are not reasonably likely to result in performance penalties or payments that would have a material adverse effect on the Company’s liquidity.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Note 8. Related Company Transactions
Balances and transactions with related companies included the following items at December 31 (in millions):
(1)
This balance is comprised primarily of receivables from KCSR originated in the normal course of business.
(2)
This balance is comprised primarily of employee services provided by KCSM Servicios.
(3)
The outstanding balance represents unsecured loan agreements with a wholly-owned subsidiary of KCS.
(4)
Notes payable to KCSR due no later than December 31, 2016, which bear interest at 1-year LIBOR plus 2.5%. These notes were issued in conjunction with the Company’s capital distributions. See Note 10 “Stockholders’ Equity.”
The most significant transactions with related parties are summarized as follows for the years ended December 31, (in millions):
____________________
(1) Terminal services are provided by FTVM and Nafta Rail.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Employee Services Agreement
On April 19, 2012, KCSM entered into an employee services agreement (the “Employee Services Agreement”) under which KCSM Servicios provides employee services to KCSM, and KCSM pays KCSM Servicios market-based rates for these services. The Employee Services Agreement became effective on May 1, 2012, and will continue in full force and effect until terminated by one party by providing written notice to the other party. During 2012, KCSM Servicios charged $131.9 million to KCSM under this agreement.
Revolving Credit Agreement
KCSM, as lender, and KCSR, as borrower, entered into a Revolving Credit Agreement effective as of April 1, 2008 (the “Revolving Agreement”), pursuant to the terms of which KCSM may make one or more loans from time to time during the term of the Revolving Agreement. The Revolving Agreement is secured by certain assets of KCSR and terminates on December 31, 2013. As of December 31, 2012 and 2011, KCSM had no outstanding amount under the terms of the Revolving Agreement.
Loan Agreements between KCSM and a Wholly-Owned Subsidiary of KCS
On September 28, 2012, KCSM entered into an unsecured loan agreement (the “Loan Agreement”) with a wholly-owned subsidiary of KCS. The Loan Agreement allows KCSM to receive one or more loans up to an aggregate principal amount of $350.0 million, due on September 30, 2017. Pursuant to the terms of the Loan Agreement, on September 28, 2012, KCSM entered into a loan agreement for $48.0 million consisting of $9.0 million in cash and $39.0 million from an outstanding principal amount under the 2009 loan agreement between KCSM and a wholly-owned subsidiary of KCS, which was amended in 2010 and subsequently terminated as part of the Loan Agreement. KCSM is required to make annual interest payments on the outstanding principal amount at a rate equivalent to annual LIBOR plus 2.00%.
On September 26, 2011, KCSM entered into an unsecured loan agreement (the “2011 Loan Agreement”) with a wholly-owned subsidiary of KCS. Pursuant to the terms of the 2011 Loan Agreement, KCSM received $17.5 million for general corporate purposes. The 2011 Loan Agreement requires KCSM to make annual interest payments at a rate equivalent to 1-year LIBOR plus 2.30%, with the principal payment due on September 30, 2016.
Management Services Agreement
On December 31, 2005, KCSM and KCS entered into a Management Services Agreement under which KCS provides to KCSM general guidance, oversight, consultation and management services in connection with the business and operations of KCSM. The Management Services Agreement became effective as of April 1, 2005, and will continue in full force and effect until terminated by one party by providing written notice to the other party. During 2012, 2011 and 2010, KCS charged $25.9 million, $27.4 million and $28.0 million, respectively, to KCSM under the agreement.
During 2011, KCSM prepaid KCSR $78.2 million for services which will be provided by KCSR through 2014. The prepayment included a discount of 3.5%. As of December 31, 2012 the prepayment balance was $48.5 million with $28.4 million included in other current assets and $20.1 million included in other assets. As of December 31, 2011, this prepayment balance was $78.2 million with $28.0 million included in other current assets and $50.2 million included in other assets.
During 2010, KCSM prepaid KCSR $18.4 million for services which were provided by KCSR during 2011, the prepayment included a discount of 3.5%. As of December 31, 2011, this prepayment balance was zero.
Service and Inventory Prepayments
During 2011, KCSM prepaid KCSR $3.0 million for inventory to be delivered by KCSR. As of December 31, 2012 and 2011, the prepayment balance was $1.3 million and $3.0 million, respectively, which was included in other current assets.
In December 2011, KCSM prepaid Nafta Rail $22.3 million for terminal services, which will be provided by Nafta Rail through 2016. The prepayment included a discount of 3.5%. As of December 31, 2012, the prepayment balance was $15.8 million with $5.1 million included in other current assets and $10.7 million included in other assets. As of December 31, 2011, the prepayment balance was $20.9 million with $5.4 million included in other current assets and $15.5 million included in other assets.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Note 9. Income Tax
Current income tax expense represents the amounts expected to be reported on the Company’s income tax returns, and deferred tax expense or benefit represents the change in net deferred tax assets and liabilities. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities as measured by the enacted tax rates that will be in effect when these differences reverse. Valuation allowances are recorded as appropriate to reduce deferred tax assets to the amount considered likely to be realized.
Tax Expense. Income tax expense consists of the following components (in millions):
The tax effects of temporary differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities are as follows at December 31 (in millions):
Tax Rates. Differences between the Company’s effective income tax rates and the Mexican statutory income tax rate of 30% follow (in millions):
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Change in Tax Law. On December 17, 2012, changes to the Mexican Federal Income Tax Law were approved. The 30% income tax rate used in 2012 will remain applicable for 2013. The planned income tax rate reduction has been postponed one year with 29% starting in 2014 and 28% in 2015. The Company’s deferred income tax assets and liabilities were revalued using the rates expected to be in effect when the underlying temporary differences are expected to reverse. This revaluation resulted in a $0.8 million expense in the 2012 tax provision.
Tax Carryovers. The Company’s loss carryovers at December 31, 2012 were $94.8 million and will begin to expire in 2015. A deferred tax asset was recorded in prior periods for the expected future tax benefit of these losses which will be carried forward to reduce only ordinary Mexican income tax payable in future years. The Company also has an asset tax credit carryover in the amount of $6.8 million which will expire in 2017.
The valuation allowance for deferred tax assets as of December 31, 2012 and 2011 was $3.4 million.
The Company believes it is more likely than not that the results of future operations will generate sufficient taxable income to realize the deferred tax assets, net of valuation allowances, related to loss carryovers and tax credits.
Uncertain Tax Positions. The accounting guidance for uncertainty in income taxes prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The guidance requires the Company to recognize in the consolidated financial statements the benefit of a tax position only if the impact is more likely than not of being sustained on audit based on the technical merits of the position. In 2012 and 2011, the Company has not taken any new uncertain tax positions and does not have a provision for uncertain tax positions as of December 31, 2012 and 2011.
Interest and penalties related to uncertain tax positions are included in income before taxes on the consolidated statements of comprehensive income. Accrued interest and penalties on unrecognized tax benefits and interest and penalty expense was immaterial to the consolidated financial statements for all periods presented.
During 2012, the 2004 tax return audit was completed without adjustment. Tax returns filed for periods after 2006 remain open to examination by the taxing authorities. The Company received an audit assessment for the year ended December 31, 2005, from the Servicio de Administracion Tributaria (the “SAT”), the Mexican equivalent of the U.S. Internal Revenue Service. The Company will initiate administrative proceedings with the SAT and if a settlement is not reached, then the matter will be litigated. The Company believes that it has strong legal arguments in its favor and more likely than not will prevail in any challenge of this assessment. The Company believes that an adequate provision has been made for any adjustment (taxes and interest) that will be due for all open years. However, an unexpected adverse resolution could have a material effect on the consolidated financial statements in a particular quarter or fiscal year.
Note 10. Stockholders’ Equity
KCSM’s capital stock is divided into Class I Shares, representing the fixed portion of the capital, and Class II Shares, representing the variable portion of the capital. The fixed portion of the capital stock with no withdrawal rights is represented by 600,000 shares. The variable portion of the capital stock is represented by 4,784,910,235 shares. As of December 31, 2012 and 2011, the total shares outstanding represented by Class I and Class II were 4,785,510,235 fully subscribed and paid for, without a par value expression.
Capital Contribution
On December 21, 2012, KCSM shareholders approved a pro-rata increase of $18.8 million in the variable portion of the common stock of the Company. KCSM used the proceeds from this contribution for various purposes. The shares representing the Company’s common stock have no par value and, therefore, the capital increase of the common stock in its variable portion, represented by Class II shares, did not result in the issuance of new shares.
On June 3, 2010, KCSM shareholders approved a pro-rata increase of $95.0 million in the variable portion of the common stock of the Company (the “Capital Contribution”). KCSM used the proceeds from the Capital Contribution to redeem $70.0 million of the 12 1/2% Senior Notes and a portion of the 9 3/8% Senior Notes, plus accrued and unpaid interest and expenses. The shares representing the Company’s common stock have no par value and, therefore, the capital increase of the common stock in its variable portion, represented by Class II shares, did not result in the issuance of new shares.
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Capital Distribution
In 2011, KCSM shareholders approved capital distributions of $335.0 million. The distributions totaled $135.0 million in cash and $200.0 million in unsecured notes payable to the Company’s shareholders. The notes were ultimately transferred to the Company’s affiliate, KCSR (the “Notes”). The Notes are payable to KCSR no later than December 31, 2016, and bear interest at an annual LIBOR plus 2.5%. Pursuant to the terms of the Notes, the Company may make one or more prepayments of principal and any and all interest accrued thereon as of such prepayment date.
Note 11. Postemployment Benefits
Postemployment Benefits. Until the organizational restructuring effective May 1, 2012, KCSM was required to provide certain postemployment benefits to its union and non-union employees. These plans provide statutorily calculated benefits which are payable upon retirement, death, disability, voluntary or involuntary termination of employees based on length of service.
Effective May 1, 2012, KCS completed an organizational restructuring whereby employees of KCSM became employees of KCSM Servicios. Accordingly, KCSM's obligation to pay postemployment benefits terminated, and KCSM Servicios assumed all of KCSM's postemployment benefit obligations incurred prior to the effective date.
During September 2010, KCSM completed negotiations with the Mexican labor union. Among other matters resolved in these negotiations, KCSM was not required to provide an incremental benefit to its union employees upon retirement. Previous to the agreement reached with the Mexican labor union, KCSM had recorded a liability for an incremental retirement benefit which was based on various factors including retirement eligibility based on a combination of age and years of credited service and the employee’s salary at the time of retirement. KCSM had no legal obligation to fund any benefit previously calculated under these factors.
The Company used December 31 as the measurement date for its postemployment benefit obligations.
Net Periodic Benefit Cost, Plan Obligation, and Funded Status
Components of the net cost (benefit) for the plan were as follows for the years ended December 31 (in millions):
(i)
Net benefit costs above do not include a component for the amortization of actuarial gains or losses as the Company’s policy is to recognize such gains and losses immediately.
The following table reconciles the change in the benefit obligation for each of the years ended December 31 (in millions):
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
Assumptions
The assumptions used to determine benefit obligations and costs are selected based on current and expected market conditions. Discount rates are selected based on the rates on low risk government bonds with cash flows approximating the timing of expected benefit payments. The Mexico bond market is utilized for the KCSM postemployment obligation.
Weighted average assumptions used to determine the benefit obligation were as follows for the years ended December 31:
Weighted average assumptions used to determine net benefit cost for the periods were as follows:
Note 12. Commitments and Contingencies
Concession Duty. Under the Concession, KCSM paid concession duty expense of 0.5% of gross revenues for the first 15 years of the Concession period, and on June 24, 2012, KCSM began paying 1.25% of gross revenues, which is effective for the remaining years of the Concession. For the year ended December 31, 2012, the concession duty expense, which is recorded within materials and other in operating expenses, was $9.4 million, compared to $4.9 million and $4.1 million for the same periods in 2011 and 2010, respectively.
Litigation. The Company is a party to various legal proceedings and administrative actions, all of which, except as set forth below, are of an ordinary, routine nature and incidental to its operations. KCSM aggressively defends these matters and has established liability provisions, which management believes are adequate to cover expected costs. Although it is not possible to predict the outcome of any legal proceeding, in the opinion of management, other than those proceedings described in detail below, such proceedings and actions should not, individually, or in the aggregate, have a material adverse effect on the Company’s consolidated financial statements.
Environmental Liabilities. The Company’s operations are subject to Mexican federal and state laws and regulations relating to the protection of the environment through the establishment of standards for water discharge, water supply, emissions, noise pollution, hazardous substances and transportation and handling of hazardous and solid waste. The Mexican government may bring administrative and criminal proceedings, impose economic sanctions against companies that violate environmental laws and temporarily or even permanently close non-complying facilities.
The risk of incurring environmental liability is inherent in the railroad industry. As part of serving the petroleum and chemicals industry, the Company transports hazardous materials and has a professional team available to respond to and handle environmental issues that might occur in the transport of such materials.
The Company performs ongoing reviews and evaluations of the various environmental programs and issues within the Company’s operations and, as necessary, takes actions intended to limit the Company’s exposure to potential liability. Although these costs cannot be predicted with certainty, management believes that the ultimate outcome of identified matters will not have a material adverse effect on the Company’s consolidated financial statements.
Certain Disputes with Ferromex. KCSM and Ferromex use certain trackage rights, haulage rights and interline services (the “Services”) provided by each other. The rates to be charged after January 1, 2009, were agreed to pursuant to the Trackage Rights Agreement, dated February 9, 2010 (the “Trackage Rights Agreement”), between KCSM and Ferromex. The rates payable for these Services for the period beginning in 1998 through December 31, 2008, are still not resolved. KCSM is currently involved in discussions with Ferromex regarding the amounts payable to each other for the Services for this period. If KCSM cannot reach an agreement with Ferromex for rates applicable for Services provided prior to January 1, 2009, which are not subject to the Trackage Rights Agreement, the SCT is entitled to set the rates in accordance with Mexican law and regulations. KCSM and Ferromex both initiated administrative proceedings seeking a determination by the SCT of the rates that KCSM and Ferromex should pay each other in connection with the Services. The SCT issued rulings in 2002 and 2008 setting
Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Notes to Consolidated Financial Statements-(Continued)
the rates for the Services, and both KCSM and Ferromex challenged these rulings. Although KCSM and Ferromex have challenged these matters based on different grounds and these cases continue to evolve, management believes the amounts recorded related to these matters are adequate.
While the outcome of these matters cannot be predicted with certainty, the Company does not believe, when resolved, that these disputes will have a material effect on its consolidated financial statements.
SCT Sanction Proceedings. On July 23, 2008, the SCT delivered notice to KCSM of proceedings against KCSM, claiming, among other things, that KCSM refused to grant Ferromex access to certain trackage over which Ferromex alleges it has trackage rights on six different occasions and thus denied Ferromex the ability to provide service to a Mexican subsidiary of a large U.S. auto manufacturer at this location. On July 15, 2010, the SCT resolved to consolidate these six sanction proceedings into a single proceeding, determining that the actions that motivated the underlying claims constitute a single occasion. On February 27, 2012, the SCT dismissed this proceeding on the basis that the extent of the Ferromex trackage rights had not been determined prior to the time KCSM refused Ferromex access.
Contractual Agreements. In the normal course of business, the Company enters into various contractual agreements related to commercial arrangements and the use of other railroads’ or governmental entities’ infrastructure needed for the operations of the business. The Company is involved or may become involved in certain disputes involving transportation rates, product loss or damage, charges, and interpretations related to these agreements. While the outcome of these matters cannot be predicted with certainty, the Company does not believe, when resolved, that these disputes will have a material effect on its consolidated financial statements.
Credit Risk. The Company continually monitors risks related to economic changes and certain customer receivables concentrations. Significant changes in customer concentration or payment terms, deterioration of customer creditworthiness or further weakening in economic trends could have a significant impact on the collectability of KCSM’s receivables and operating results. If the financial condition of KCSM’s customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. The Company has recorded provisions for uncollectability based on its best estimate at December 31, 2012.
Note 13. Derivative Instruments
The Company does not engage in the trading of derivative financial instruments except where the Company’s objective is to manage the variability of forecasted fuel price risk. In general, the Company enters into derivative transactions in limited situations based on management’s assessment of current market conditions and perceived risks. However, management intends to respond to evolving business and market conditions and in doing so, may enter into such transactions more frequently as deemed appropriate.
Fuel Derivative Transactions. During the years ended December 31, 2012 and 2011 the Company did not enter into any fuel swap agreements. In the first quarter of 2010, the Company entered into fuel swap agreements to hedge 6.6 million gallons of diesel fuel purchases through the end of 2010 at an average swap price per gallon of $2.15, which were not designated as hedging instruments. For the year ended December 31, 2010, the Company recognized a gain of $0.4 million for fuel swap contracts which were not designated as hedging instruments in fuel expense in the consolidated statements of comprehensive income.
Note 14. Subsequent Event
On January 30, 2013, the Company entered into a forward contract with a notional amount of $65.0 million to hedge its exposure to foreign currency risk. The contract obligates the Company to purchase a total of Ps.853.0 million at an exchange rate of Ps.13.12 to each U.S. dollar with a maturity date of December 31, 2013. The Company has not designated this forward contract as a hedging instrument for hedge accounting purposes. The Company will mark the contract to market at the end of each reporting period and recognize any foreign exchange gain or loss within the consolidated statements of comprehensive income.
Item 9.
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None
Item 9A.
Item 9A.
Controls and Procedures
(a) Disclosure Controls and Procedures
The President and Executive Representative and the Chief Financial Officer have reviewed and evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)), as of the end of the fiscal year for which this annual report on Form 10-K is filed. Based on that evaluation, the President and Executive Representative and the Chief Financial Officer have concluded that the Company’s current disclosure controls and procedures are effective to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission rules and forms, and include controls and procedures designed to ensure that information required to be disclosed by the Company in such reports is accumulated and communicated to the Company’s management, including the President and Executive Representative and the Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
(b)
Change in Internal Control over Financial Reporting
There have been no changes in the Company’s internal control over financial reporting that occurred during the last fiscal quarter (the fourth quarter in the case of an annual report) that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.
(c) Internal Control over Financial Reporting
The report of management on the Company’s internal control over financial reporting (as defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act) is included as “Management’s Report on Internal Control over Financial Reporting” in Item 8.
Item 9B.
Item 9B.
Other Information
None.
Part III
Items 10, 11, 12 and 13. Directors, Executive Officers and Corporate Governance; Executive Compensation; Security Ownership of Certain Beneficial Owners and Management and Related Stockholders Matters; and Certain Relationships and Related Transactions, and Director Independence
Omitted pursuant to General Instruction I(2) to Form 10-K.
Item 14.
Item 14.
Principal Accountant Fees and Services
The following table presents the total fees for KCS and KCSM for professional audit services and other services rendered by KPMG LLP, the Company’s Independent Registered Public Accounting Firm, to KCS and KCSM for the years ended December 31, 2012 and 2011 (in thousands).
Pre-Approval Policy
KCSM is a wholly owned subsidiary of KCS and does not have an Audit Committee of its Board of Directors. Services provided by the Company’s Independent Registered Public Accounting Firm and all fees are subject to pre-approval policies and procedures of the Audit Committee of the Board of Directors of KCS.
The Audit Committee’s pre-approval policies and procedures, as described in its charter, provide that the Audit Committee will approve all services and fees for audit and non-audit services prior to engagement. The Chair of the Audit Committee is authorized to pre-approve any audit and non-audit services on behalf of the Audit Committee, provided that such decisions are provided to the full Audit Committee at its next scheduled meeting.
The Audit Committee pre-approved all services provided by KPMG LLP, Independent Registered Public Accounting Firm, for the year ended December 31, 2012 and 2011.
Part IV
Item 15.
Item 15.
Exhibits and Financial Statement Schedules
(a) List of documents filed as part of this report:
(1)
Financial Statements
The consolidated financial statements and related notes, together with the report of KPMG LLP, Independent Registered Public Accounting Firm, appears in Part II Item 8, Financial Statements and Supplementary Data, of this Form 10-K.
(2)
Financial Statement Schedules
None.
(3)
List of Exhibits
The Company has attached or incorporated by reference herein certain exhibits as specified below pursuant to Rule 12b-32 under the Exchange Act.
(a) Exhibits
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Kansas City Southern de México, S.A. de C.V.
By
/s/ José Guillermo Zozaya Delano
José Guillermo Zozaya Delano
President and Executive Representative
February 4, 2013
POWER OF ATTORNEY
Know all people by these presents, that each person whose signature appears below constitutes and appoints José Guillermo Zozaya Delano and Michael W. Upchurch, and each of them, his or her true and lawful attorneys-in-fact and agents, with full power of substitution and resubstitution, for him or her and in his or her name, place and stead, in any and all capacities, to sign any amendments to this annual report on Form 10-K, and to file the same, with all exhibits thereto, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully and to all intents and purposes as he or she might or could do in person, hereby confirming all that said attorneys-in-fact and agents or either of them, or his or their substitute or substitutes, may lawfully do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Company and in the capacities indicated on February 4, 2013.
Signature
Title
/s/ Michael R. Haverty
President of the Board of Directors and Director
Michael R. Haverty
/s/ José Guillermo Zozaya Delano
President and Executive Representative
(Principal Executive Officer)
José Guillermo Zozaya Delano
/s/ Michael W. Upchurch
Chief Financial Officer
(Principal Financial Officer)
Michael W. Upchurch
/s/ Mary K. Stadler
Chief Accounting Officer
(Principal Accounting Officer)
Mary K. Stadler
/s/ David L. Starling
Vice President of the
Board of Directors and Director
David L. Starling
/s/ Patrick J. Ottensmeyer
Director
Patrick J. Ottensmeyer
/s/ David R. Ebbrecht
Director
David R. Ebbrecht
/s/ Antonio O. Garza, Jr.
Director
Antonio O. Garza, Jr.
Kansas City Southern de México, S.A. de C.V.
2012 Form 10-K Annual Report
Index to Exhibits