SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

 

 

Commission File Number 333-08322

 

KANSAS CITY SOUTHERN DE MÉXICO, S.A. DE C.V.

(Exact name of Company as specified in its charter)

 

Kansas City Southern of Mexico

(Translation of Registrant’s name into English)

 

 

(5255) 9178-5686

(Company’s telephone number, including area code)

 

No Changes

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

 

 

Indicate by check mark whether the Company (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Company was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o Not applicable o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes o     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

(Do not check if a smaller reporting company)

 

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

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of March 31, 2010: 4,785,510,235

 

Kansas City Southern de México, S.A. de C.V. meets the conditions set forth in General Instruction H(1)(a) and (b) of Form 10-Q and is therefore filing this form with the reduced disclosure format.

 

 

Kansas City Southern de México, S.A. de C.V. and Subsidiaries
Form 10-Q
March 31, 2010

Index

 

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Form 10-Q
March 31, 2010

 

 

The Consolidated Financial Statements included herein have been prepared by Kansas City Southern de México, S.A. de C.V. (“KCSM” or the “Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). For the purposes of this report, unless the context otherwise requires, all references herein to “KCSM” and the “Company” shall mean Kansas City Southern de México, S.A. de C.V. and its subsidiaries. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations. The Company believes that the disclosures are adequate to enable a reasonable understanding of the information presented. The Consolidated Financial Statements and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-Q should be read in conjunction with the consolidated financial statements and the related notes, as well as Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. Results for the three months ended March 31, 2010 are not necessarily indicative of the results expected for the full year ending December 31, 2010.

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

Consolidated Statements of Income

 

 

See accompanying notes to consolidated financial statements.

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

Consolidated Balance Sheets

 

 

See accompanying notes to consolidated financial statements.

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

Consolidated Statements of Cash Flows

 

 

See accompanying notes to consolidated financial statements.

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements

(Amounts in millions of U.S. dollars)

 

 

In the opinion of the management of KCSM, the accompanying unaudited consolidated financial statements contain all adjustments necessary for a fair presentation of the results for interim periods. All adjustments made were of a normal recurring nature. Certain information and footnote disclosures normally included in financial statements prepared in accordance with U.S. GAAP have been condensed or omitted. These consolidated financial statements should be read in conjunction with the consolidated financial statements and accompanying notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. The results of operations for the three months ended March 31, 2010, are not necessarily indicative of the results expected for the full year ending December 31, 2010. Certain prior year amounts have been reclassified to conform to the current year presentation.

 

During the third quarter of 2009, the Company identified that changes in accounts payable and accrued liabilities related to capital spending had not been correctly presented in the Company’s prior period consolidated cash flow statements. Changes in these accruals had previously been classified within cash flows from operating activities and should have been classified as capital expenditures within investing activities, in order to report capital expenditures on a cash basis rather than on an accrual basis. The accompanying consolidated cash flow statement for the three months ended March 31, 2010 presents capital expenditures on a cash basis. The accompanying consolidated cash flow statement for the three months ended March 31, 2009 has been revised to present capital expenditures on a cash basis. This revision did not impact the change in cash and cash equivalents as previously reported, however, net cash provided by operating activities, capital expenditures and cash used by investing activities increased by $20.5 million for the three months ended March 31, 2009. This revision did not impact operating income or net income and working capital as previously reported.

 

During the first quarter of 2010, the Company elected to change its accounting policy for rail grinding costs from a capitalization method to a direct expense method. Previously, the Company capitalized rail grinding costs as an improvement to the rail. The Company believes it is preferable to expense these costs as incurred to eliminate the subjectivity in determining the period of benefit associated with rail grinding over which to depreciate the associated capitalized costs. The Company has reflected this change as a change in accounting principle from an accepted accounting principle to a preferable accounting principle in accordance with Accounting Standards Codification 250 “Accounting for Changes and Error Corrections”. Comparative financial statements for all periods have been adjusted to apply the change in accounting principle retrospectively.

 

This change in accounting principle did not impact the consolidated statements of income for the three months ended March 31, 2009.

 

The following line items in the consolidated balance sheet were affected by the change in accounting principle (in millions):

 

 

The change in accounting principle and the revision related to the classification of capital expenditures on a cash basis rather than on an accrual basis did not have an impact on the change in cash and cash equivalents

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements — (Continued)

 

in the consolidated statement of cash flows; however, the following line items were affected by these adjustments (in millions):

 

 

As of January 1, 2008, the cumulative effect of the change in accounting principle on property and equipment (including concession assets), deferred income tax liability, other noncurrent liabilities and deferred credits and retained earnings was ($3.9) million, ($1.0) million, ($0.4) million and ($2.5) million, respectively.

 

 

Effective January 1, 2010, the Company adopted the Financial Accounting Standards Board (the “FASB”) Accounting Standards Update (“ASU”) No. 2009-17, “Improvements to Financial Reporting by Enterprises Involved with Variable Interest Entities” (“ASU 2009-17”). ASU 2009-17 addresses the elimination of certain exceptions to consolidating qualifying special-purpose entities, which means more entities will be subject to consolidation assessments and reassessments. The new guidance requires ongoing reassessment of whether a company is the primary beneficiary of a variable interest entity (“VIE”) and clarifies characteristics that identify a VIE. In addition, ASU 2009-17 requires additional disclosures about a company’s involvement with a VIE and any significant changes in risk exposure due to that involvement. The adoption of ASU 2009-17 did not have any impact on the Company’s results of operations and financial condition.

 

 

Property and Equipment.  Property and equipment, including concession assets, and related accumulated depreciation and amortization are summarized below (in millions):

 

 

Concession assets, net of accumulated amortization of $264.7 million and $259.4 million, totaled $1,774.7 million and $1,768.0 million at March 31, 2010 and December 31, 2009, respectively.

 

 

At March 31, 2010, KCSM had financial assets and financial liabilities denominated in Mexican pesos of Ps.1,218.5 million and Ps.580.5 million, respectively. At December 31, 2009, KCSM had financial assets and financial liabilities denominated in Mexican pesos of Ps.1,355.2 million and Ps.833.4 million, respectively. At March 31, 2010 and at December 31, 2009, the exchange rate was Ps.12.46 and Ps.13.06, per U.S. dollar, respectively.

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements — (Continued)

 

 

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 the fair value due to their short term nature.

 

The fair value of the Company’s debt is estimated using quoted market prices when available. When quoted market prices are not available, fair value is estimated based on current market interest rates for debt with similar maturities. The fair value of the Company’s debt was $1,174.6 million and $1,170.0 million at March 31, 2010 and December 31, 2009, respectively. The financial statement carrying value was $1,131.9 million and $1,136.1 million at March 31, 2010 and December 31, 2009, respectively.

 

Assets and liabilities recognized at fair value are required to be classified into a three-level hierarchy. In general, fair values determined by Level 1 inputs utilize quoted prices (unadjusted) in active markets for identical assets or liabilities that the Company has the ability to access. Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability. Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability. In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value in its entirety requires judgment and considers factors specific to the asset or liability.

 

At March 31, 2010 the fair value of the Company’s fuel swap agreements was $0.8 million. Fair value is determined using a level 2 valuation.

 

 

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.

 

Fuel Derivative Transactions.  In the first quarter of 2010, the Company entered into fuel swap agreements, which have not been designated as hedging instruments. Gains and losses relating to these derivatives are recorded in fuel expense in the consolidated statements of income. As of March 31, 2010, the Company has outstanding fuel swap agreements for 6.6 million gallons of diesel fuel purchases, from July 1, 2010 through December 31, 2010 at an average swap price of $2.15 per gallon. At March 31, 2010, the fair value of the fuel swaps agreements was $0.8 million, which was included in other current assets on the consolidated balance sheet. The Company recognized a gain of $0.8 million in fuel expense related to fuel swaps agreements.

 

 

Other comprehensive income refers to revenues, expenses, gains and losses that under U.S. GAAP are included in comprehensive income, a component of stockholders’ equity within the consolidated balance sheets, rather than net income. Under existing accounting standards, other comprehensive income for KCSM

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements — (Continued)

 

reflects the cumulative translation adjustment on Ferrocarril y Terminal del Valle de México, S.A. de C.V. (“FTVM”).

 

KCSM’s total comprehensive income is as follows (in millions):

 

 

 

On January 7, 2010, pursuant to an offer to purchase, KCSM commenced a cash tender offer for a portion of its 93/8% senior unsecured notes due May 1, 2012 (the “93/8% Senior Notes”). On January 22, 2010, the Company purchased $290.0 million of the tendered 93/8% 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 $300.0 million of 8.0% senior unsecured notes due February 1, 2018 (the “8.0% Senior Notes”). Additionally, on February 1, 2010, the Company purchased $6.3 million of the 93/8% Senior Notes. KCSM recorded debt retirement costs of $14.9 million in the first quarter of 2010. The remaining 93/8% Senior Notes mature on May 1, 2012 and are redeemable by KCSM at its option.

 

On January 22, 2010, KCSM issued 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 81/4%. KCSM used the net proceeds from the issuance of the 8.0% Senior Notes and cash on hand to purchase $290.0 million in principal amount of 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 93/8% Senior Notes 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% and 2016 — 100.000%. In addition, KCSM may redeem up to 35% of the 8.0% Senior Notes any time prior to February 1, 2013 from the proceeds of the sale of capital stock in KCSM or KCS and the notes are redeemable, in whole but not in part, at KCSM’s option at their principal amount in the event of certain changes in the Mexican withholding tax rate.

 

The 8.0% Senior Notes are denominated in dollars and 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 8.0% Senior Notes include certain covenants which are customary for these types of debt instruments and borrowers with similar credit ratings. The 8.0% Senior Notes contain certain covenants that, among other things, prohibit or restrict KCSM for taking certain actions, including the ability to incur debt, pay dividends or make other distributions in respect of our stock, issue guarantees, enter into certain transactions with affiliates, make restricted payments, sell certain assets, create liens, engage in sale-leaseback transactions and engage in mergers, divestitures and consolidations. However, these limitations are subject to a number of important qualifications and exceptions.

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements — (Continued)

 

 

On March 3, 2010, the Company acquired an intermodal facility in Mexico. The aggregate purchase price for the intermodal facility was $25.0 million, which was funded by existing cash. The Company has determined that the acquisition is not material to the Company’s consolidated financial statements; therefore, pro forma financial information is not presented. In addition, the Company has made a preliminary purchase allocation as of March 31, 2010, based on incomplete valuations. The Company expects to complete the purchase valuation during the second quarter of 2010.

 

 

Concession duty.  Under KCSM’s railroad concession from the Mexican government (the “Concession”), the Mexican government has the right to receive a payment from the Company equivalent to 0.5% of the gross revenue during the first 15 years of the Concession period and 1.25% during the remaining years of the Concession period. For the three months ended March 31, 2010 and 2009, the concession duty expense amounted to $1.0 million and $0.7 million, respectively, which was recorded within operating expenses.

 

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. Included in these proceedings are various tort claims brought by current and former employees for job-related injuries and by third parties for injuries related to railroad operations. KCSM aggressively defends these matters and has established liability reserves, 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 financial condition and liquidity. However, a material adverse outcome in one or more of these proceedings could have a material adverse impact on the operating results of a particular quarter or fiscal year.

 

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 and 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 and handle environmental issues that might occur in the transport of such materials.

 

Settlement Agreement.  On February 9, 2010, (i) KCSM and (ii) Ferrocarril Mexicano, S.A. de C.V. (“Ferromex”), Ferrosur, S.A. de C.V. (“Ferrosur”), Minera México, S.A. de C.V., Infraestructura y Transportes Ferroviarios, S.A. de C.V., Infraestructura y Transportes México, S.A. de C.V., Líneas Ferroviarias de México, S.A. de C.V., Grupo Ferroviario Mexicano, S.A. de C.V., and Grupo México, S.A.B. de C.V. (jointly, the “Ferromex Parties”) entered into a Settlement Agreement (the “Settlement Agreement”).

 

Pursuant to the Settlement Agreement, the parties agreed to completely, definitively and irrevocably terminate (i) the private disputes, procedures and controversies among KCSM and the Ferromex Parties, in connection with the merger between Ferromex and Ferrosur, including KCSM’s involvement in such procedures as an interested party; and (ii) the lawsuit filed against KCSM and the Mexican Government in connection with several disputes, procedures and controversies before judicial authorities with respect to the acquisition of the shares of Ferrocarril del Noreste, S.A. de C.V. (now KCSM) by Grupo Transportación Ferroviaria Mexicana, S.A. de C.V., in 1997 (the “Settlement Procedures”). The parties waived their rights to

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements — (Continued)

 

any future actions derived from or related to the Settlement Procedures. Further, the parties did not settle or agree to settle any disputes, controversies or procedures other than the Settlement Procedures.

 

Under the Settlement Agreement, Ferrosur agreed to grant KCSM certain trackage and switching rights within Veracruz, México, and switching rights in the Puebla-Tlaxcala zone. In a related agreement, the parties further agreed to amend the FTVM by-laws to, among other changes, grant certain veto and voting rights to KCSM at the shareholders’ and the board of directors’ levels.

 

The Settlement Agreement shall remain in effect until the term of the concession title of KCSM expires, unless the parties mutually agree to renew the Settlement Agreement beyond the expiration of KCSM’s concession title. The Settlement Agreement may be terminated earlier upon delivery by KCSM of a notice to the Ferromex Parties indicating any breach by the Ferromex Parties of any of their respective obligations under the Settlement Agreement. Notwithstanding, the settlement and termination of the Settlement Procedures shall not be subject to rescission or termination.

 

The Settlement Agreement may be terminated, at KCSM’s option, before its stipulated term if Ferromex is sold or if it transfers, directly or indirectly, its concession under its concession title. A change in control of KCSM or its affiliates, however, shall not be a cause for termination. Likewise, the Settlement Agreement will terminate three years after Ferromex and Ferrosur cease to be under the common control of one person or group of persons acting jointly or in agreement to adopt coordinated resolutions (“Common Control”). Notwithstanding, if for any reason Ferromex and Ferrosur are under Common Control within five years after the Settlement Agreement is terminated due to Ferromex and Ferrosur ceasing to be under Common Control, the Settlement Agreement would automatically be reinstated.

 

In November 2005, Ferromex acquired control of and merged with Ferrosur creating Mexico’s largest railway, though such merger has been previously rejected by the Comisión Federal de Competencia (Mexican Antitrust Commission) (“COFECO”). If the COFECO does not authorize the merger of Ferromex and Ferrosur, the Settlement Agreement shall be terminated twelve months after the relevant resolution of the Governmental Authority is issued or when the unwinding is effective, whichever is later.

 

Trackage Rights Settlement Agreement with Ferromex.  KCSM operations are subject to certain trackage rights, switching rights, and interline services with Ferromex. KCSM and Ferromex entered into a Trackage Rights, Switching and Interline Settlement Agreement, dated February 9, 2010 (the “Trackage Rights Agreement”). Pursuant to the Trackage Rights Agreement, the parties terminated, in a definitive and irrevocable manner, all actions and procedures regarding: (a) rates applicable to trackage rights, switching and interlinear services from January 1, 2009 onward, but not regarding the applicable rates before January 1, 2009 or the amounts owed by the parties to one another prior to the execution of the Trackage Rights Agreement; (b) the scope of certain trackage rights in Monterrey, Nuevo León, Guadalajara, Jalisco and Altamira, Tamaulipas, and Aguascalientes; and (c) court costs, as well as any other directly-related issue or dispute that arises from, is related in any manner directly or indirectly with, the terms and conditions and/or scope of such mandatory trackage and/or switching rights or that arises by reason of the definition of trackage rights (the “Settlement Controversies”). The parties waived their rights to any future actions derived from or related to the Settlement Controversies. Further, KCSM and Ferromex set the rates applicable for January 1, 2009 for each party for the use of the other party’s trackage. The retroactive application of these rates to January 1, 2009 did not have a material impact on the results of operations for the quarter ended March 31, 2010.

 

Explicitly excluded from the scope and purpose of the Trackage Rights Agreement are all procedures, disputes, lawsuits, remedies, appeals and disagreements that were not expressly identified in the Trackage Rights Agreement, including without limitation, the disputes, claims and lawsuits that relate to the determination of rates for mandatory trackage and/or switching rights and for interconnection and/or terminal services, accrued prior to January 1, 2009, as well as the disputes among the parties regarding amounts payable to one another for trackage rights, interline services and switching services, that are currently being disputed by both parties at the

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements — (Continued)

 

Federal Court of Fiscal and Administrative Justice. Furthermore, the parties did not settle or agree to settle any other trackage and switching rights not specifically mentioned in the Trackage Rights Agreement.

 

The Trackage Rights Agreement shall remain in effect until the term of the concession title of Ferromex or the concession title of KCSM expire, unless the parties mutually agree to renew the Trackage Rights Agreement beyond the expiration of either party’s concession title. The Trackage Rights Agreement may be terminated, at KCSM’s option, before its stipulated term if Ferromex is sold or if it transfers, directly or indirectly, its concession under its concession title. A change in control of KCSM or its affiliates, however, shall not be a cause for termination.

 

Certain Disputes with Ferromex.  KCSM’s operations are subject to certain trackage rights, haulage rights, and interline services (the “Services”) with Ferromex. Other than the rates to be charged pursuant to the Trackage Rights Agreement, dated February 9, 2010, between KCSM and Ferromex, the rates payable for these services have not been agreed upon by KCSM and Ferromex for the periods beginning in 1998 through December 31, 2008. If KCSM cannot reach an agreement with Ferromex for rates applicable for services prior to January 1, 2009 which are not subject to the Trackage Rights Agreement, the Mexican Secretaría de Comunicaciones y Transportes (“Ministry of Communications and Transportation” or “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 the rates for the services and both KCSM and Ferromex challenged these rulings.

 

In addition, KCSM is currently involved in judicial, civil and administrative proceedings and negotiations with Ferromex regarding the rates payable to each other for the Services for the periods prior to January 1, 2009. 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 and does not believe there will be a future material impact to the results of operations arising out of these disputes.

 

SCT Sanction Proceedings.  In April 2006, the SCT initiated proceedings against KCSM, claiming that KCSM had failed to make certain minimum capital investments projected for 2004 and 2005 under its five-year business plan filed with the SCT prior to its April 2005 acquisition by KCS (collectively, the “Capital Investment Proceedings”). KCSM believes it made capital expenditures exceeding the required amounts. KCSM responded to the SCT by providing evidence in support of its investments and explaining why it believes sanctions are not appropriate. In May 2007, KCSM was served with an SCT resolution regarding the Capital Investment Proceeding for 2004, in which the SCT resolved to impose no sanction. In June 2007, KCSM was served with an SCT resolution regarding the Capital Investment Proceeding for 2005, in which the SCT determined that KCSM had indeed failed to make the minimum capital investments required for such year, and imposed a minimum fine. KCSM has filed an action in the Mexican Administrative and Fiscal Federal Court challenging this ruling. KCSM will have the right to challenge any adverse ruling.

 

In May 2008, the SCT initiated a proceeding against KCSM, at the request of a Mexican subsidiary of a large U.S. Auto Manufacturer (the “Auto Manufacturer”), alleging that KCSM impermissibly bundled international rail services and engaged in discriminatory pricing practices with respect to rail services provided by KCSM to the Auto Manufacturer. In March 2009, the SCT issued a decision determining that KCSM had engaged in the activities alleged, but imposed no sanction since this was the first time KCSM had engaged in such activities. On May 6, 2009, KCSM challenged the SCT’s decision and the appeal is currently pending in the Administrative and Fiscal Federal Court.

 

On July 23, 2008, the SCT delivered notice to KCSM of new 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

Kansas City Southern de México, S.A. de C.V. and Subsidiaries

 

Notes to Consolidated Financial Statements — (Continued)

 

service to the Auto Manufacturer at this location. On August 13, 2008, KCSM filed a response to the SCT and final resolution is pending.

 

KCSM believes it has defenses to the imposition of sanctions for the foregoing proceedings and intends to vigorously contest these allegations. KCSM does not believe that these SCT proceedings will have a material adverse effect on KCSM’s results of operations or financial condition. However, if KCSM is ultimately sanctioned by the SCT for “generic” sanctions on five occasions over the term of the Concession, KCSM could be subject to possible future SCT action seeking revocation of the Concession.

 

Disputes Relating to the Provision of Services to the Auto Manufacturer.  KCSM is involved in several disputes related to providing service to the Auto Manufacturer.

 

In March 2008, the Auto Manufacturer filed an arbitration suit against KCSM under a contract for services to the Auto Manufacturer’s plants in Mexico, which, as amended, had a stated termination date of January 31, 2008. Among other claims, the Auto Manufacturer claimed that the contract was implicitly extended and continued in effect beyond its stated termination date. The Auto Manufacturer is seeking a declaration by the arbitrator that the rates being assessed by KCSM are discriminatory, even though the rates being charged are within the legal rate limits set by Mexican law for such freight transportation. KCSM claimed that the contract did in fact expire on its stated termination date, and that services rendered thereafter are thus subject to the general terms and conditions (including rates) applicable in the absence of a specific contract, pursuant to Mexican law. Accordingly, KCSM filed a counterclaim against the Auto Manufacturer to, among other things, recover the applicable rate difference between the rates under the contract and KCSM’s rates. The arbitration was divided in two phases. On May 18, 2009, the arbitrator issued an award on the first phase of the arbitration proceeding, ruling that the contract had terminated on May 8, 2008. As of the date of this filing, the second phase of the arbitration proceeding, regarding the claim that the rates assessed by KCSM are discriminatory, is in the evidentiary stage and has not been resolved. Management believes the final resolution of these claims will not have any material impact on KCSM’s results of operations.

 

Credit Risk.  The Company continually monitors risks related to economic changes and certain customer receivable concentrations. Significant changes in customer concentration or payment terms, deterioration of customer credit-worthiness 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 reserves for uncollectability based on its best estimate at March 31, 2010.

 

Income Tax.  Tax returns filed in Mexico from 2003 through the current year remain open to examination by the taxing authority in Mexico. The 2003 through 2005 tax returns are currently under examination. The Company received an audit assessment for the year ended December 31, 2003, from Servicio de Administracion Tributaria (the “SAT”), the Mexican equivalent of the IRS. The Company filed its response to this assessment on March 8, 2010, and continues to negotiate with the SAT. If a settlement is not reached, the matter will be litigated. The Company believes that it has strong legal arguments in its favor and will more likely than not ultimately prevail in any challenge of this assessment. The Company believes that an adequate provision has been made for any adjustment (tax and interest) that will be due for all open years. However, an unexpected adverse resolution could have a material effect on the results of operations in a particular quarter or fiscal year.

 

The Board of Directors and Stockholders

Kansas City Southern de México, S.A. de C.V.:

 

We have reviewed the accompanying consolidated balance sheet of Kansas City Southern de México, S.A. de C.V. and subsidiaries (the Company) as of March 31, 2010, and the related consolidated statements of income and cash flows for the three-month periods ended March 31, 2010 and 2009. These consolidated financial statements are the responsibility of the Company’s management.

 

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States). A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the consolidated financial statements taken as a whole. Accordingly, we do not express such an opinion.

 

Based on our review, we are not aware of any material modifications that should be made to the consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

 

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2009, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated February 11, 2010, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of December 31, 2009 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

 

KPMG LLP

 

Kansas City, Missouri

April 27, 2010

 

The discussion below, as well as other portions of this Form 10-Q, contain forward-looking statements that are not based upon historical information. Such forward-looking statements are based upon information currently available to management and management’s perception thereof as of the date of this Form 10-Q. 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. The actual results of operations of Kansas City Southern de México, S.A. de C.V. (the “Company” or “KCSM”) could materially differ from those indicated in forward-looking statements. The differences could be caused by a number of factors or combination of factors including, but not limited to, those factors identified in Item 1A — Risk Factors of the Company’s Annual Report on Form 10-K for the year ended December 31, 2009, which is on file with the U.S. Securities and Exchange Commission (File No. 333-08322) and which “Risk Factors” section is hereby incorporated by reference herein. Readers are strongly encouraged to consider these factors when evaluating forward-looking statements. Forward-looking statements contained in this Form 10-Q will not be updated.

 

The following discussion, which is intended to clarify and focus on the Company’s results of operations, certain changes in its financial position, liquidity, capital structure and business developments for the periods covered by the consolidated financial statements included under Item 1 of this Form 10-Q, is abbreviated pursuant to General Instruction H(2)(a) of Form 10-Q. This discussion should be read in conjunction with those consolidated financial statements and the related notes, and is qualified by reference to them.

 

Critical Accounting Policies and Estimates

 

The Company’s discussion and analysis of its financial position and results of operations is based upon its consolidated financial statements. The preparation of these consolidated financial statements requires estimation and judgment that affect the reported amounts of revenue, expenses, assets, and liabilities. The Company bases its estimates on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the accounting for assets and liabilities that are not readily apparent from other sources. If the estimates differ materially from actual results, the impact on the consolidated financial statements may be material. The Company’s significant accounting policies are disclosed in the 2009 Annual Report on Form 10-K.

 

During the first quarter of 2010, the Company elected to change its accounting policy for rail grinding costs from a capitalization method to a direct expense method. Refer to Note 1, Accounting Policies, Interim Financial Statements and Basis of Presentation, for further details of this change in accounting policy. Comparative financial information for all prior periods have been adjusted to reflect the retroactive application of this change in accounting principle.

 

Management’s narrative analysis relates to the financial condition and results of operations of KCSM and its subsidiaries.

Results of Operations.

 

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

 

 

Revenues.

 

The following table 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 three months ended March 31, 2010, revenues increased $53.5 million compared to the same period in 2009, primarily due to the overall increase in carload/unit volumes resulting from the relative improvement in the economy, positive pricing impacts, the effect of fluctuations in the value of the U.S. dollar against the value of the Mexican peso for revenues denominated in Mexican pesos and increased fuel surcharge. Revenue per

carload/unit increased by 10% for the three months ended March 31, 2010, compared to the same period in 2009, due to increases in pricing and fuel surcharge.

 

KCSM’s fuel surcharge is a mechanism to adjust revenue based upon changing fuel prices. Fuel surcharges are calculated differently depending on the type of commodity transported. For most commodities, fuel surcharge is calculated using a fuel price from a prior time period that can be as much as 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:

 

 

Coal.  Revenue decreased $0.6 million for the three months ended March 31, 2010, compared to the same period in 2009, primarily due to a decrease in volume and shorter length of haul.

 

Intermodal.  Revenues increased $8.8 million for the three months ended March 31, 2010, compared to the same period in 2009, primarily due to an increase in volume. Growth was driven by increased automotive parts traffic, conversion of cross border truck traffic to rail, haulage and trans-Pacific container volume due to inventory replenishment, a rebound in North American demand for automobiles and improvement in the economy.

Automotive.  Revenues increased $8.9 million for the three months ended March 31, 2010, compared to the same period in 2009, primarily due to increases in volume, fluctuations in the value of the U.S. dollar against the value of the Mexican peso and fuel surcharge. The volume increase was driven by strong year over year growth in North American automobile sales and an increase in parts and vehicle volume driven by a shift in production and distribution patterns from the U.S. to Mexico.

 

Operating expenses.

 

Operating expenses, as shown below (in millions), increased $13.5 million for the three months ended March 31, 2010, when compared to 2009, primarily due to increased carload/unit volumes and the effect of fluctuations in the value of the U.S. dollar against the value of the Mexican peso for operating expenses denominated in Mexican pesos.

 

 

Compensation and benefits.  Compensation and benefits increased $5.9 million for the three months ended March 31, 2010, compared to the same period in 2009, primarily due to an increase in statutory profit sharing expenses, increases in compensation and benefits due to fluctuations in the value of the U.S. dollar against the value of the Mexican peso and annual wage and salary rate increases. These increases were partially offset by lower employee headcount as compared to the prior year.

 

Purchased services.  Purchased services expense increased $3.8 million for the three months ended March 31, 2010, compared to the same period in 2009, due to increases in corporate services provided by a related company, volume-sensitive costs including joint facilities, security, and track and terminal services. These increases were partially offset by lower locomotive maintenance as a result of a newer locomotive fleet and having fewer locomotives covered by maintenance agreements.

 

Fuel.  Fuel expense increased $8.2 million for the three months ended March 31, 2010, compared to the same period in 2009. The increase was driven by higher consumption due to the increase in traffic volume, higher fuel prices and fluctuations in the value of the U.S. dollar against the value of the Mexican peso.

 

Equipment costs.  Equipment costs decreased $2.1 million for the three months ended March 31, 2010, compared to the same period in 2009, primarily due to a decrease in freight car lease expense, which was partially offset by an increase in the use of other railroads’ freight cars and car leases.

 

Depreciation and amortization.  Depreciation and amortization expenses decreased $4.0 million for the three months ended March 31, 2010, compared to the same period in 2009, primarily due to a change in the estimated useful lives of certain Mexican concession assets, which was effective as of October 1, 2009. In addition, depreciation expense decreased due to the impact of lower rates based on the depreciation study completed in third quarter 2009. Depreciation expense on the asset base as of year-end 2009 will be lower on a quarterly basis by approximately $2.6 million due to the change in estimated useful lives of certain Mexican concession assets and approximately $0.5 million as a result of lower rates based on the depreciation study.

Casualties and insurance.  Casualties and insurance expenses decreased $0.6 million for the three months ended March 31, 2010, compared with the same period in 2009, primarily due to a lower derailment activity and environmental expense.

 

Materials and other.  Materials and other expenses increased $2.3 million for the three months ended March 31, 2010, compared to the same period in 2009, primarily due to a settlement related to a legal dispute and increases in other employee expenses and concession duty.

 

Non-Operating Expenses

 

Equity in net earnings of unconsolidated affiliates.  Equity in earnings from unconsolidated affiliates was $1.5 million for the three months ended March 31, 2010, compared to $0.5 million the same period in 2009. Significant components of this change are as follows:

 

 

Interest expense.  Interest expense increased $5.4 million for the three months ended March 31, 2010, compared to the same period 2009. The increase in interest expense was primarily attributable to higher debt balances and average interest rates.

 

Debt retirement cost.  Debt retirement costs for the three months ended March 31, 2010 and 2009 were $14.9 million and $0.6 million, respectively. In the first quarter of 2010, KCSM purchased $296.3 million of its 93/8% Senior Notes due May 1, 2012. The Company recorded debt retirement costs of $14.9 million related to the call premium and the write-off of unamortized debt issuance costs. In March 2009, KCSM repaid all amounts outstanding under, and terminated, its credit agreement and upon termination, wrote-off the unamortized debt issuance cost related to this debt.

 

Foreign exchange.  For the three months ended March 31, 2010 and 2009, the foreign exchange gain was $2.8 million compared to a foreign exchange loss of $5.1 million, primarily due to fluctuations in the value of the U.S. dollar against the value of the Mexican peso.

 

Other income, net.  Other income, net consists primarily of miscellaneous interest income. For the three months ended March 31, 2010, other income, net was $0.5 million compared to $0.3 million in the same period 2009.

 

Income tax (benefit) expense.  For the three months ended March 31, 2010, the income tax expense was $7.6 million as compared to an $11.5 million income tax benefit for the same period in 2009. The effective income tax rate was 40.6% and (107.5%) for the three months ended March 31, 2010 and 2009, respectively. The changes in income tax expense and the effective tax rate were primarily due to higher pre-tax income, foreign exchange rate fluctuations and an increase in the statutory income tax rate from 28% to 30%.

 

Liquidity and Capital Resources

 

Overview

 

KCSM’s primary uses of cash are to support operations; maintain and improve its railroad; pay debt service; acquire new and maintain existing locomotives, rolling stock and other equipment; and meet other obligations. KCSM’s cash flow from operations has historically been sufficient to fund operations, maintenance capital expenditures and debt service. External sources of cash (principally bank debt, public and private debt and leases) have been used to refinance existing indebtedness and to fund acquisitions, new investments and equipment additions. As of March 31, 2010, total available liquidity was approximately $108.9 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 has no significant debt maturities until 2012.

 

As of March 31, 2010, KCSM has a debt capitalization ratio (total debt as a percentage of total debt plus total equity) of 46.0 percent. Its primary sources of liquidity are cash flows generated from operations and access to debt capital markets. Although KCSM has had adequate access to the debt capital markets, as a non-investment grade company, the financial terms under which funding is obtained often contain restrictive covenants. The covenants constrain financial flexibility by restricting or prohibiting certain actions, including 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, pay dividends on common stock, make investments, engage in transactions with stockholders and affiliates, sell certain assets, and engage in mergers and consolidations or in sale leaseback transactions. These restrictions, however, are subject to a number of qualifications and exceptions that provide the Company with varying levels of additional borrowing capacity. The Company was in compliance with all of its debt covenants as of March 31, 2010.

 

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 economic factors surrounding debt 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.

 

On January 7, 2010, pursuant to an offer to purchase, KCSM commenced a cash tender offer for a portion of its 93/8% Senior Notes. On January 22, 2010, the Company purchased $290.0 million of the tendered 93/8% 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 $300.0 million of 8.0% senior unsecured notes due February 1, 2018 (the “8.0% Senior Notes”). Additionally, on February 1, 2010, the Company purchased $6.3 million of the 93/8% Senior Notes. KCSM recorded debt retirement costs of $14.9 million in the first quarter of 2010. The remaining 93/8% Senior Notes mature on May 1, 2012 and are redeemable by KCSM at its option.

 

On January 22, 2010, KCSM issued 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 81/4%. KCSM used the net proceeds from the issuance of the 8.0% Senior Notes and cash on hand to purchase $290.0 million in principal amount of 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 93/8% Senior Notes 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% and 2016 — 100.000%. In addition, KCSM may redeem up to 35% of the 8.0% Senior Notes any time prior to February 1, 2013 from the proceeds of the sale of capital stock in KCSM or KCS and the notes are redeemable, in whole but not in part, at KCSM’s option at their principal amount in the event of certain changes in the Mexican withholding tax rate.

 

The 8.0% Senior Notes are denominated in dollars and 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 8% Senior Notes include certain covenants which are customary for these types of debt instruments and borrowers with similar credit ratings. The 8.0% Senior Notes contain certain covenants that, among other things prohibit or restrict KCSM for taking certain actions, including the ability to incur debt, pay dividends or make other distributions in respect of our stock, issue guarantees, enter into certain transactions with affiliates, make restricted payments, sell certain assets, create liens, engage in sale-leaseback transactions and engage in mergers,

divestitures and consolidations. However, these limitations are subject to a number of important qualifications and exceptions.

 

Standard & Poor’s Rating Services (“S&P”) rates the Company’s senior unsecured debt as B+ and improved the outlook to stable. Moody’s Investors Service (“Moody’s”) rates the Company’s senior unsecured debt as B2 and improved the outlook to stable.

 

Cash Flow Information

 

Summary cash flow data follows (in millions):

 

 

As compared to the three months ended March 31, 2009, cash flows from operating activities increased $15.3 million primarily as a result of increased net income from higher carload/unit volumes due to the recovery of the economy. Net investing cash outflows decreased $23.3 million due to lower capital expenditures, and net proceeds received from a loan to a related company. These decreases were partially offset by the acquisition of an intermodal facility in Mexico in the first quarter of 2010. Additional information regarding capital expenditures is provided below. Financing cash inflows decreased $109.6 million. During the three months ended March 31, 2010, the Company purchased $296.3 million of the 93/8% Senior Notes due 2012 and paid debt cost of $18.9 million, which was partially offset by the proceeds from the issuance of the 8.0% Senior Notes of $295.7 million. During the three months ended March 31, 2009, the Company received proceeds of $189.0 million from the issuance of the 121/2% Senior Notes due 2016, partially offset by the capital reduction to the Company’s shareholders and repayment of borrowings under its credit agreement, which has been terminated.

 

Capital Expenditures

 

Capital improvements are generally funded with cash flows from operations. KCSM has historically used external sources such as loans or lease financing for capacity and equipment acquisition.

 

The following summarizes the capital expenditures by type (in millions):

 

 

 

Omitted pursuant to General Instruction H(2)(c) of Form 10-Q.

 

(a) Disclosure Controls and Procedures.

 

As of the end of the period for which this Quarterly Report on Form 10-Q is filed, the Company’s President and Executive Representative and Chief Financial Officer have each reviewed and evaluated the effectiveness of the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”)). Based on that evaluation, the President and Executive Representative and Chief Financial Officer have each concluded that the Company’s current disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports that it files or submits 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 Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure.

 

(b) Changes in Internal Control over Financial Reporting.

 

There have not been any changes in the Company’s internal controls over financial reporting that occurred during the first quarter of 2010 that have materially affected, or are reasonably likely to materially affect, the Company’s internal controls over financial reporting.

 

 

Not applicable.

 

 

For information related to the Company’s settlement and other legal proceedings, see Note 10 “Commitments and Contingencies,” under Part I, Item 1, of this quarterly report on Form 10-Q.

 

 

There were no material changes during the quarter in the Risk Factors disclosed in Item 1A, “Risk Factors,” in KCSM’s Annual Report on Form 10-K for the fiscal year ended December 31, 2009.

 

 

Omitted pursuant to General Instruction H(2)(b) of Form 10-Q.

 

 

Omitted pursuant to General Instruction H(2)(b) of Form 10-Q.

 

 

 

None.

 

 

 

*Certain portions of these exhibits have been omitted pursuant to our request for confidential treatment under Rule 24b-2 of the Securities Exchange Act of 1934, as amended.

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized and in the capacities indicated on April 27, 2010.

 

Kansas City Southern de México, S.A. de C.V.

 

Michael W. Upchurch

Chief Financial Officer

(Principal Financial Officer)

 

Mary K. Stadler

Chief Accounting Officer

(Principal Accounting Officer)