UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

 

Form 10-K

 

 

Commission file number 333-08322

 

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

(Exact Name of Registrant as Specified in Its Charter)

 

Kansas City Southern of Mexico

(Translation of Registrant’s name into English)

 

 

+ (5255) 9178-5686

(Address, Including Zip Code, and Telephone Number, Including Area Code, of Registrant’s Principal Executive Offices)

 

 

 

 

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

None

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

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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

 

Indicate by check mark 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o (Not applicable)

 

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):

 

 

Indicate by check mark whether the registrant is a shell company.  Yes o     No þ

 

State the aggregate market value of the voting and non-voting common equity held by non-affiliates: Not applicable

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: 4,785,510,235.

 

Kansas City Southern de México, S.A. de C.V. is a wholly-owned subsidiary of Kansas City Southern; as a result, there is no market data with respect to registrant shares.

 

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

 

DOCUMENTS INCORPORATED BY REFERENCE:

Not applicable.

 

 

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

 

2009 FORM 10-K ANNUAL REPORT

 

Table of Contents

 

 

Unless otherwise indicated or the context otherwise requires, all references in this Annual Report to “KCSM” or the “Company,” or similar terms refer to Kansas City Southern de México, S.A. de C.V., together with its subsidiaries, and references to “KCS” refer to Kansas City Southern, a Delaware corporation that, as of September 12, 2005, became KCSM’s ultimate parent. References to “Grupo KCSM” refer to Grupo KCSM, S.A. de C.V., and references herein to “$,” “U.S. dollars” or “dollar” are to the lawful currency of the United States of America. References herein to “peso,” “Ps.” and “Mexican pesos” are to the lawful currency of Mexico.

 

Cautionary Statement Regarding Forward-Looking Statements

 

You should carefully review the information contained in this Annual Report on Form 10-K and in other reports or documents that the Company files from time to time with the Securities and Exchange Commission (the “SEC”). In this Annual Report on Form 10-K, the Company states its beliefs of future events and future financial performance. In some cases, you can identify those so-called “forward-looking statements” by words such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” or “continue” or the negative of those words and other comparable words. You should be aware that those statements are only the Company’s predictions. Actual events or results may differ materially. In evaluating those statements, you should specifically consider various factors, including the risks discussed in this Annual Report on Form 10-K and other reports or documents that the Company files from time to time with the SEC. Those factors may cause actual results to differ materially from any forward-looking statements. All forward-looking statements attributable to the Company or a person acting on its behalf are expressly qualified in their entirety by this cautionary statement.

 

 

COMPANY HISTORY

 

KCSM commenced operations in June 1997 under a 50-year Concession (the “Concession”) granted by the Mexican government to provide freight transportation services over the Northeast Rail Lines, the first rail lines to be privatized in the Mexican railroad system. Prior to the privatization, KCS and Grupo TMM, S.A. (“Grupo TMM”) jointly formed and invested in KCSM’s former parent, Grupo KCSM, with KCS owning a 36.9% economic interest (49% of the shares entitled to full voting rights) and Grupo TMM owning a 38.5% economic interest (51% of the shares entitled to full voting rights). In 2002, KCSM purchased the remaining 24.6% of Grupo KCSM held by the Mexican government. This transaction increased KCS’ ownership in Grupo KCSM to a 46.6% economic interest and Grupo TMM’s ownership in Grupo KCSM to a 48.5% economic interest.

 

On April 1, 2005, KCS completed the acquisition from Grupo TMM of all of Grupo TMM’s shares of Grupo KCSM, giving KCS ownership of 100% of the shares of Grupo KCSM entitled to full voting rights. As of April 1, 2005, Grupo KCSM owned 80% of the Company’s share capital (which represented all of KCSM’s shares with full voting rights), while the remaining 20% of KCSM (with limited voting rights) was owned by the Mexican government. Accordingly, KCS became KCSM’s controlling stockholder through its ownership of Grupo KCSM on April 1, 2005.

 

On September 12, 2005, Grupo KCSM and KCS, along with Grupo TMM, entered into a settlement agreement with the Mexican government resolving certain disputes and controversies between the companies and the Mexican government concerning the payment of a refund of the value added taxes (“VAT”) paid when the Concession Title and certain other assets were transferred to KCSM and Grupo KCSM’s obligation to purchase the remaining shares of KCSM owned by the Mexican government. As a result of this settlement, KCS and its subsidiaries obtained ownership of 100% of both Grupo KCSM and KCSM and the Mexican government’s remaining 20% ownership interest in KCSM was redeemed and cancelled; the potential obligation of KCS, Grupo KCSM and Grupo TMM to acquire the Mexican government’s remaining 20% interest in KCSM was eliminated; and the legal obligation of the Mexican government to issue the VAT refund to KCSM was satisfied.

 

On December 20, 2006, after receiving shareholder approval, KCSM amended its by-laws to transform KCSM into a sociedad de responsabilidad limitada de capital variable (limited liability corporation).

 

On April 2, 2007, KCSM adopted corporate resolutions approving: (i) KCSM’s conversion (“Re-transformation”) from a sociedad de responsabilidad limitada de capital variable (limited liability corporation) to a sociedad anónima de capital variable (variable capital corporation) and (ii) the legal merger, (the “2007 Merger”) of Grupo KCSM with KCSM, with KCSM as the surviving corporation. The Re-transformation and the 2007 Merger became effective on May 8, 2007, the date on which the corresponding corporate resolutions were filed for registry within the Mexican Public Registry of Commerce (Registro Público de Comercio).

 

BUSINESS OVERVIEW

 

KCSM 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 2,600 miles of main track. In addition, KCSM has trackage rights entitling it to run its trains over 700 miles of track of other Mexican railroad operators. KCSM provides freight transportation services under its 50-year 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-Laredo, which is the largest freight exchange point between Mexico and the U.S. Through KCS’ U.S. rail subsidiaries, 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 congested U.S. west coast ports of Long Beach and Los Angeles. KCSM is the sole provider of rail service to this port, which provides an alternate route for Asian traffic bound for the eastern, southern and midwestern United States. Traffic at Lazaro Cardenas is both domestic and import traffic, consisting of intermodal containers, minerals, iron, steel slabs, wire rods and fertilizers.

 

KCSM’s revenues are derived from the movement of a diversified mix of commodities and products mainly attributable to cross-border traffic with the U.S. The Company transports chemical and petroleum products, industrial and consumer products, agricultural and mineral products, intermodal and automotive products, and coal. KCSM’s customers include leading international and Mexican corporations.

 

Kansas City Southern

 

KCSM is a wholly-owned subsidiary of KCS. KCS’ principal U.S. subsidiary, The Kansas City Southern Railway Company (“KCSR”), is a U.S. Class I railroad. The rail network of KCSR, The Texas Mexican Railway Company (“Tex-Mex”) and KCSM together comprise approximately 6,000 miles of main and branch lines extending from the midwest and southeast portions of the United States into Mexico.

 

RAIL SECURITY

 

KCS and its rail subsidiaries have made a concentrated, multi-disciplinary effort since the terrorist attacks on the United States on September 11, 2001, to continue securing KCS’ 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’ security activities range from periodically mailing each employee a security awareness brochure (which is also posted under the “Employees” tab on KCS’ internet website, www.kcsouthern.com) to its ongoing development and implementation of security plans for rail facilities in areas labeled by the DHS as

High Threat Urban Areas (“HTUAs”). KCS’ other activities to bolster security against terrorism include, but are not limited to, the following:

 

 

In addition, in 2008 KCS created a new leadership role titled “Director of Homeland Security” to oversee the ongoing and increasingly complex security efforts. KCS identified and retained an individual to fill the position who has an extensive law enforcement background, including being formerly employed as an analyst with the Federal Bureau of Investigation (“FBI”) for 12 years. This member of management remains a member of the FBI’s Joint Terrorism Task Force and is a valuable asset to the Company in implementing and developing anti-terrorism and other security initiatives.

 

While the risk of theft and vandalism is higher in Mexico, KCSM remains among the safest 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 of checks and balances, 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 train velocity, which reduces the likelihood for incidents to occur. By moving customers’ shipments more efficiently, KCSM is keeping the cargo secure.

 

AVAILABLE INFORMATION

 

KCS’ 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 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).

 

 

Risk Factors Relating to KCSM Debt

 

The Company’s substantial indebtedness could adversely affect its financial position and its ability to meet its obligations under its debt instruments.

 

KCSM has a substantial amount of debt and significant debt service obligations. As of December 31, 2009, KCSM had total outstanding indebtedness of $1,136.1 million, consisting of (i) $989.7 million of senior unsecured indebtedness, (ii) $118.4 million of senior secured indebtedness and capital lease obligations and (iii) $28.0 million of unsecured debt with another wholly-owned subsidiary of KCS and equipment debt. KCSM’s stockholders’ equity was $1,334.8 million as of December 31, 2009, resulting in a debt ratio (total debt as a percentage of total debt plus equity) of 46.0%.

 

KCSM’s substantial indebtedness could make it more difficult for it to borrow money in the future and may reduce the amount of money available to finance its operations and other business activities, including the following:

 

 

 

Failure to comply with restrictive covenants in KCSM’s existing contractual arrangements could accelerate KCSM’s repayment obligations under its indentures relating to its debt.

 

The indentures relating to KCSM’s outstanding debt securities contain a number of restrictive covenants, and any additional financing arrangements KCSM enters into may contain additional restrictive covenants. These covenants restrict or prohibit many actions, including, but not limited to, KCSM’s ability to incur debt, create or suffer to exist liens, make prepayments of particular debt, pay dividends, make investments, engage in transactions with stockholders and affiliates, issue capital stock, sell certain assets, and engage in mergers and consolidations or in sale-leaseback transactions. Failure to maintain compliance with the covenants contained in the indentures could constitute a default which could accelerate the payment of any amounts outstanding under these financial agreements.

 

A downturn in debt capital markets may increase the cost of borrowing and make financing difficult to obtain, each of which could have a material adverse effect on the Company’s results of operations and business.

 

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. The negative impact of tightening credit markets, and adverse changes in the debt capital markets generally, may have a material adverse effect on KCSM’s results of business and operations resulting from, but not limited to, an inability to finance capital expansion on favorable terms, if at all, increased financing cost or financial terms with increasingly restrictive covenants.

 

Risk Factors Relating to KCSM’s Business

 

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 its business and financial condition.

 

KCSM operates under the Concession granted by the Mexican government, which is renewable for up to 50 years, subject to certain conditions. The Concession gives KCSM exclusive rights to provide freight transportation services over its rail lines for 30 years of the 50-year Concession, subject to certain trackage and haulage rights granted to other concessionaires. The Secretaría de Comunicaciones y Transportes (Ministry of Communications) (“SCT”), which is principally responsible for regulating railroad services in Mexico, has broad powers to monitor KCSM’s compliance with the Concession and 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 regulations, the SCT, in consultation with The Comisión Federal de Competencia (Mexican Antitrust Commission), (“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 services 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 KCSM 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 its rail lines. All other property not covered by the Concession, including all locomotives and railcars otherwise acquired, will remain KCSM’s property. The Mexican government would have the right to cause KCSM 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 Mexican government must exercise this right within four months after revocation of the Concession. In addition, the Mexican government will 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 timely made.

 

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. 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 KCSM’s debt. 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.

 

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.

 

KCSM believes that even if the sanction is ultimately imposed as a consequence of the 2005 Capital Investment Proceeding, there will be no material adverse effect on its results of operations or financial condition. However, if a sanction were to be imposed it would be considered a “generic” sanction under Mexican law (i.e., sanctions applied to conduct not specifically referred to in specific subsections of the Mexican railway law). 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. Such revocation would materially adversely affect the results of operations and financial condition of KCSM.

 

Failure to make capital expenditures could result in the revocation of KCSM’s Concession and adversely affect its financial condition.

 

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 its 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 or accommodate increases in traffic volumes.

 

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 occasions. KCSM 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 financial condition and results of operations. 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 funds from operating cash flows, equipment leases, and debt financing. 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 obtained on acceptable terms and within the limitations contained in the indentures and other agreements relating to KCSM’s existing debt.

 

KCSM competes against other railroads and other transportation providers.

 

KCSM’s operations are subject to competition from other railroads, particularly Ferrocarril Méxicano, S.A. de C.V (“Ferromex”) and Ferrosur in Mexico, as well as from truck carriers, barge lines and other maritime shippers. Certain rail competitors are much larger and have 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 results of operations and financial condition.

 

In recent years, there has also been significant consolidation among major North American rail carriers. The resulting merged railroads could attempt to use their size and pricing power to block other railroads’ access to efficient gateways and routing options that are currently and have been historically available. There

can be no assurance that further consolidation in the railroad industry, whether in the United States or Mexico, will not have an adverse effect on operations.

 

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 KCSM 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 results of operations, financial condition and liquidity.

 

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 have the ability to convert traffic from truck to rail transport or that the customers already converted will be retained. If the railroad industry in general is unable to preserve its competitive advantages vis-à-vis the trucking industry, projected revenue growth from KCSM’s operations could be adversely affected. Additionally, the revenue growth attributable to KCSM’s operations 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 the North America Free Trade Agreement (“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 may be adversely affected by changes in general economic conditions, including the automotive industry, which has had difficulties in recent years.

 

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 affect the businesses served by KCSM. Prolonged negative changes in domestic and global economic conditions or disruptions of either or both from the financial and credit markets, including the availability of short-term 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 results of operations, financial condition and liquidity.

 

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. For example, global steel and petrochemical prices have decreased in the past and reduced demand for automotive vehicles and related shipments may result in decreased prices. 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 financial condition or results.

 

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. KCSM’s operations are also dependent on interchange, trackage rights, haulage rights and marketing agreements with other railroads and third parties that enable KCSM to exchange traffic and utilize trackage the Company does not own. 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. The termination

of, or the failure to renew, these agreements could adversely affect KCSM’s business, financial condition and results of operations. KSCM is also dependent in part upon the financial health and efficient performance of other railroads with which KCSM has agreements. There can be no assurance that KCSM will not be materially adversely affected by operational or financial difficulties of other railroads.

 

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 results of operations, financial condition and liquidity. 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 business, results of operations, financial condition and liquidity.

 

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 business.

 

KCSM’s business is subject to credit risk. There is a 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 receivables and 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 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. Although all of these trackage rights have been granted under the Concession, KCSM and Ferromex have not actually operated under the long distance trackage rights because, other than the rates to be charged pursuant to the Trackage Rights Agreement, dated February 9, 2010, between KCSM and Ferromex, the rates that may be charged for the right to use the tracks have not been agreed upon between 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 SCT is entitled to set the rates in accordance with Mexican law and regulations, which rates may not adequately compensate KCSM. KCSM is currently involved in judicial, civil and administrative proceedings and negotiations with Ferromex regarding the rates 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 negative impact on its results of operations in a particular quarter of fiscal year.

 

Downturns in the U.S. economy, Mexican economy, U.S.-Mexico trade, certain cyclical industries in which KCSM’s customers operate, the global economy or fluctuations in the peso-dollar exchange rate could have adverse effects on KCSM’s financial condition.

 

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 results of operations and its ability to meet debt service obligations. In addition, KCSM has invested significant amounts in developing its intermodal operations at the Port of Lazaro Cardenas, in part to provide Asian importers with an alternative to 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 business and results of operations.

 

Also, fluctuations in the peso-dollar exchange rate could lead to shifts in the types and volumes of Mexican imports and exports. Although a decrease in the level of exports of some of the commodities that KCSM transports to the United States may be offset by a subsequent increase in imports of other commodities KCSM hauls into Mexico and vice versa, any offsetting increase might not occur on a timely basis, if at all. Future developments in 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.

 

Any devaluation of the peso would cause the peso cost of KCSM’s dollar-denominated debt to increase, adversely affecting its ability to make payments on its indebtedness. Severe devaluation or depreciation of the peso may result in disruption of the international foreign exchange markets and may limit the ability to transfer pesos or to convert pesos into U.S. dollars for the purpose of making timely payments of interest and principal on the non-peso denominated indebtedness. Although the Mexican government currently does not restrict, and for many years has not restricted, the right or ability of Mexican or foreign persons or entities to convert pesos into U.S. dollars or to transfer foreign currencies out of Mexico, the Mexican government could, as in the past, institute restrictive exchange rate policies that could limit the ability to transfer or convert pesos into U.S. dollars or other currencies for the purpose of making timely payments of the U.S. dollar-denominated debt and contractual commitments. Currency fluctuations are likely to continue to have an effect on KCSM’s financial condition in future periods.

 

Traffic congestion or similar problems experienced in the U.S. or Mexican railroad system may adversely affect KCSM’s operations.

 

Traffic congestion experienced in the U.S. 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 its business and results of operations. 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 business and results of operations.

 

If KCSM’s primary fuel supply contract is terminated, or if fuel prices substantially increase, its financial condition could be materially adversely affected.

 

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 operating results. During periods of rising fuel prices, KCSM has been able to pass the majority of these fuel cost increases on to customers in the form of fuel surcharges applied either in the form of an increase in the freight rate or direct customer billings. 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 operating results, financial condition and cash flows.

 

KCSM currently meets, and expects to continue to meet, fuel requirements for KCSM’s operations almost exclusively through purchases at market prices from PEMEX Refinanción (“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. 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.

 

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 FTVM and significant portions of KCSM’s customer base, could have a material adverse effect on KCSM’s operations and its financial condition. KCSM maintains insurance that is consistent with industry practice in compliance with the requirements of its Concession against the accident-related risks involved in the conduct of its business and business interruption due to natural disaster. However, this insurance is subject to a number of limitations on coverage, depending on the nature of the risk insured against. This insurance may not be sufficient to cover 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 and an adverse effect on KCSM’s financial condition.

 

KCSM depends on the stability and availability 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 violations, regulatory compliance failures and the inability to protect corporate information assets against intruders or other operational difficulties. Although KCSM has taken steps to mitigate these risks, a significant disruption could adversely affect KCSM’s results of operations, financial condition, liquidity and ability to compete effectively. Additionally, if KCSM is unable to acquire or implement new technology, it may suffer a competitive disadvantage, which could also have an adverse effect on KCSM’s results of operations, financial condition or liquidity.

 

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 Mexican applicable 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, which could have a material adverse effect on KCSM’s results of operations, financial condition and liquidity.

 

KCSM’s business is subject to tax, environmental, health, and safety laws and regulations that could require KCSM to incur material costs or liabilities relating to tax, environmental, health, or safety compliance or remediation. KCSM’s failure to comply with these regulations could have a material adverse effect on its operations.

 

KCSM is subject to income taxes and non-income-based taxes in Mexico. Significant judgment is required in determining the provision for income taxes and other tax liabilities. Changes in tax rates, enactment of new tax laws, and revisions of tax regulations could have a material adverse affect on the Company’s financial condition and operating results. Although KCSM believes the tax estimates are reasonable, the final determination of tax audits, claims, or litigation could differ from what is reflected in KCSM’s income tax provisions and accruals.

 

In the operation of a railroad, it is possible that derailments, explosions or other accidents may occur that could cause harm to the environment or to human life or health. As a result, 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. KCSM 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 results of operations, cash flows or financial condition. 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’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 results of operations, financial condition, and cash flows. These acts may also impact the Company’s ability to raise capital or its future business opportunities. 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 cargo robberies in Mexico. 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.

Renegotiation of terms of the labor agreement and any potential labor disruptions could adversely affect its financial condition.

 

KCSM 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 and improving conditions for the union employees. Approximately 80% of KCSM’s 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 terms are renegotiated every two years. In June 2009, the negotiation of the compensation terms and all other benefits was started with the Mexican Railroad Union. The anticipated resolutions of these negotiations are not expected to have a material impact to the consolidated financial statements. The union labor negotiation with the Mexican Railroad Union has not historically resulted in disruption in our business operations.

 

KCSM’s controlling stockholder’s interests may be different from KCSM’s.

 

As of April 1, 2005, KCS became KCSM’s controlling stockholder with full power to direct its business. KCS on its own can make decisions and determine corporate transactions, mergers, consolidations, dividend payments, and other matters. 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.

 

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 the recently implemented multiparty rule, will have on the Mexican economy. Furthermore, KCSM’s financial condition, results of operations and prospects may be affected by currency fluctuations, inflation, interest rates, regulation, taxation, social instability and other political, social and economic developments in or affecting Mexico.

 

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

 

The Mexican economy in the past has suffered balance of payment deficits and shortages in foreign exchange reserves. Though 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 dollars or to convert pesos 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 business and financial condition.

 

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

 

Mexico has a history of high levels of inflation and may experience high inflation in the future. During most of the 1980s and during the mid and late 1990s, Mexico experienced periods of high levels of inflation. The annual rate 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 2009, 6.5% in 2008, and 3.8% in 2007. A substantial increase in the Mexican inflation rate would have the effect of increasing some of KCSM’s costs, which could adversely affect its results of operations and financial condition. High levels of inflation may also affect the

balance of trade between Mexico and the United States, and other countries, which could adversely affect KCSM’s results of operations.

 

Risk Factors Relating to Ongoing Litigation

 

KCSM is a party to various legal proceedings and administrative actions arising in the ordinary course of business including those specifically mentioned below.

 

KCSM was named as a defendant in a lawsuit, which if adversely resolved, could result in KCS being ordered to return the stock of KCSM to the Federal Government of Mexico, thus losing its Concession to operate its Mexican railroad

 

On December 9, 2009, KCSM was notified of a lawsuit filed by Minera México, S.A. de C.V. (“Minera México”), a subsidiary of Grupo México, S.A.B. de C.V. and an affiliate of Ferromex, against the Federal Government of Mexico, the SCT, Ferrocarriles Nacionales de México (“FNM”), KCSM, Nafta Rail, S.A. de C.V., a subsidiary of KCS (“Nafta Rail”), and KCS. The lawsuit claims that after the privatization bidding process for the acquisition of a majority interest in Ferrocarril del Noreste, S.A. de C.V. (“FNE”) (now KCSM) had concluded in 1997, in which the bidding was awarded to Transportación Ferroviaria Mexicana, S. de R.L. de C.V. (“TFM”) and the relevant stock purchase agreement was signed, the defendants improperly amended the stock purchase agreement and the purchasers paid a price lower than the price offered. The lawsuit alleges that the Mexican Federal Government, the SCT, FNM, KCSM, Nafta Rail and KCS violated a variety of the rules and regulations associated with the privatization bidding process. As a result of these alleged improprieties, Minera México claims the acquisition of FNE by KCS (through TFM) should be declared null and void and, consequently, the capital stock of FNE should be returned to the Federal Government of Mexico and Minera México, as the second place bidder in the bidding process, should be awarded the right to purchase the capital stock of FNE. On February 9, 2010, Minera México agreed to dismiss this lawsuit.

 

Disputes Relating to the Provision of Services to a Mexican subsidiary of a Large U.S. Auto Manufacturer.  KCSM is involved in several disputes related to providing service to a Mexican subsidiary of a large U.S. Auto Manufacturer (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. 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.

 

In May 2008, the SCT initiated a proceeding against KCSM, at the request of a Mexican subsidiary of a large U.S. 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 service to the Auto Manufacturer at this location.

 

KCSM believes it has defenses to the imposition of sanctions for the forgoing 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. Revocation of the Concession would materially adversely affect KCSM’s results of operations and financial condition.

 

 

None.

 

 

Under its Concession from the Mexican government, KCSM has the right to operate approximately 2,600 miles of main and branch lines, including 700 miles of trackage rights but does not own the land, roadway or associated structures. The Concession requires KCSM to make investments as described in a business plan filed every five years with the Mexican government. KCSM may defer capital expenditures with respect to its five-year business plan with the permission of the SCT. However, should the SCT not grant this permission, KCSM’s failure to comply with the commitments in its business plan could result in fines and ultimately the Mexican government revoking the Concession. 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 its business and financial condition.”

 

Equipment Configuration

 

KCSM owned or leased the following units of equipment at December 31:

 

 

 

The Company, at the date of this filing, has approximately 100 locomotives in storage, which primarily reflects the current economic environment and some seasonality. Management believes that this equipment will be needed in the foreseeable future as the Company grows and/or economic conditions improve. The Company

has continued to depreciate all stored locomotives; older locomotives will be retired in the normal course of business or in some cases disposed of through re-sale.

 

 

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 — Risks Factors Relating to Ongoing Litigation” and Item 8, “Financial Statements and Supplementary Data — Note 11 Commitments and Contingencies,” and Item 9B, “Other Information.”

 

 

Omitted pursuant to General Instruction I(2) to Form 10-K.

 

 

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, the Company can pay cash dividends permitted by applicable law, subject to certain limitations.

 

On December 22, 2009 and September 22, 2008, the Company declared a cash dividend on its common stock of Ps.41.2 million or $3.2 million and Ps.75.0 million or $7.1 million, respectively, to the Company’s shareholders, all subsidiaries of KCS. These dividends do not relate to earnings from the operations of KCSM. The dividends reflect pass-through of related company dividends from the Company’s equity investment in FTVM. The Company had not declared or paid dividends on its common stock before September 22, 2008.

 

 

Omitted pursuant to General Instruction I(2) to Form 10-K.

 

 

The following discussion and analysis relates to KCSM’s consolidated financial condition and results of operations for the relevant periods and is based on, and should be read in conjunction with, KCSM’s consolidated financial statements included under Item 8 of this Annual Report, “Consolidated Financial Statements and Supplementary Data.” The following discussion and analysis contains forward-looking statements that involve risks and uncertainties. KCSM’s actual results may differ materially from those anticipated in these forward-looking statements as a result of a number of factors, including those set forth under Item 1A of this Annual Report, “Risk Factors.” See “Forward-Looking Statements” for cautionary statements concerning forward-looking statements.

 

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

RESULTS OF OPERATIONS

 

Year Ended December 31, 2009 Compared to the Year Ended December 31, 2008

 

The following summarizes the consolidated income statement components of KCSM (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 year ended December 31, 2009, revenues decreased $202.5 million compared to 2008, primarily due to the overall decrease in carload/unit volumes due to the downturn in the economy and the effect of unfavorable fluctuations in the value of the U.S. dollar against the value of the Mexican peso for revenues denominated in Mexican pesos, partially offset by an increase in core pricing.

 

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 significantly differ.

 

The following discussion provides an analysis of revenues by commodity group:

 

 

Coal.  Revenues decreased $7.8 million for the year ended December 31, 2009 compared to 2008, primarily due to decreases in volume and length of haul. Petroleum coke shipments within Mexico decreased due to a market slowdown in the cement and steel industries.

 

Intermodal.  Revenues decreased $8.1 million for the year ended December 31, 2009 compared to 2008, primarily due to a decrease in volume due to the loss of business driven by unfavorable fluctuation in the value of U.S. dollar against the value of the Mexican peso. Steamship volume decreases were driven by reduced demand in consumer retail and continued aggressive truck competition. This decrease was partially offset by a fourth quarter increase in cross border automotive part shipments.

Automotive.  Revenues decreased $50.7 million for the year ended December 31, 2009 compared to 2008, due to a decline in volume and unfavorable fluctuations in the value of the U.S. dollar against the value of the Mexican peso. The volume decrease was driven by the continued overall downturn in the automotive industry caused by consumer uncertainty and tightening credit markets. In addition, the bankruptcy of two U.S. automotive companies resulted in several unscheduled plant shutdowns. The decline in volume was partially offset by U.S. government incentive programs that were established during the second and third quarters of 2009.

 

Operating Expenses

 

Operating expenses, as shown below (in millions), decreased $96.6 million for the year ended December 31, 2009, when compared to 2008, primarily due to decreased carload/unit volumes, the effect of favorable fluctuations in the value of the U.S. dollar against the value of the Mexican peso for operating expenses denominated in Mexican pesos, and cost containment measures. Certain prior period amounts have been reclassified to conform to the current year presentation.

 

 

Compensation and benefits.  Compensation and benefits decreased $29.0 million for the year ended December 31, 2009, compared to 2008, primarily due to labor reductions in response to declining carload/unit volumes, with further expense decreases due to favorable fluctuations in the value of the U.S. dollar against the value of the Mexican peso.

 

Purchased services.  Purchased services expense decreased $27.5 million for the year ended December 31, 2009, compared to 2008. The decrease is primarily due to lower locomotive maintenance expense as a result of fewer locomotives in service, newer fleet and renegotiated maintenance contracts. Corporate expenses, switching and terminal services decreased as a result of cost containment measures and lower volumes, respectively. In addition, the Company recognized a deferred credit of $6.1 million related to the partial cancellation of a maintenance contract in 2009.

 

Fuel.  Fuel expense decreased $25.7 million for the year ended December 31, 2009, compared to 2008. The decrease was driven by lower consumption due to the decrease in traffic volume, favorable fluctuations in the value of the U.S. dollar against the value of the Mexican peso and increased fuel efficiency.

 

Equipment costs.  Equipment costs decreased $12.9 million for the year ended December 31, 2009, compared to 2008, primarily due to a decrease in the use of other railroads’ freight cars, partially offset by an increase in certain car lease expenses.

 

Depreciation and amortization.  Depreciation and amortization expense decreased $0.8 million for the year ended December 31, 2009, compared to 2008, primarily due to the full year impact of lower rates based on the scheduled depreciation study completed in 2009. In addition, depreciation expense decreased due to a change in the estimated useful lives of certain concession assets. These decreases were partially offset by an increase in depreciation expense due to a larger asset base.

Casualties and insurance.  Casualty and insurance expenses decreased $2.3 million for the year ended December 31, 2009, compared to 2008, primarily due to fewer derailments and lower average cost per derailment, partially offset by an increase in freight loss and damage expenses.

 

Materials and other.  Materials and other expenses increased $1.6 million for the year ended December 31, 2009, compared to 2008, primarily due to legal settlements in 2009. In addition, 2008 included a reduction in a legal reserve. These increases were partially offset by a decrease in other employee expenses and concession duty.

 

Non-Operating Expenses

 

Equity in net earnings of unconsolidated affiliates.  Equity in earnings from unconsolidated affiliates was $2.9 million and $7.4 million for the years ended December 31, 2009 and 2008, respectively. Significant components of this change are as follows:

 

 

Interest expense.  Interest expense increased $23.5 million for the year ended December 31, 2009, compared to 2008. The increase was attributable to higher debt balances and average interest rates. In addition, in 2009, the Company recognized interest expense from an unfavorable litigation outcome.

 

Foreign exchange.  For the year ended December 31, 2009, the foreign exchange gain was $2.2 million compared to a foreign exchange loss of $21.3 million for 2008, 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 year ended December 31, 2009, other income, net was $3.1 million, compared to $2.9 million for 2008.

 

Income tax expense.  For the year ended December 31, 2009, the Company’s income tax expense was $0.2 million, a decrease of $14.8 million as compared to $15.0 million for 2008. The effective income tax rate was 2.8% for the year ended December 31, 2009, as compared to 12.7% for 2008. The changes in income tax expense and the effective income tax rate were due to lower pre-tax income in 2009, foreign exchange rate fluctuations and a change in Mexican tax rates for the years 2010 through 2013.

 

LIQUIDITY AND CAPITAL RESOURCES

 

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 December 31, 2009, total available liquidity was approximately $92.6 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. On January 28, 2009 and on September 29, 2009, KCSM declared and paid capital reductions of $65.0 million and $36.0 million, respectively, to the Company’s shareholders.

As of December 31, 2009, 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 December 31, 2009.

 

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.

 

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

 

Long-Term Debt

 

On March 30, 2009, KCSM issued $200.0 million of 121/2% senior unsecured notes due April 1, 2016 (the “121/2% Senior Notes”), which bear interest semiannually at a fixed annual rate of 121/2%. The 121/2% Senior Notes were issued at a discount to par value, resulting in an $11.0 million discount and a yield to maturity of 133/4%. The 121/2% Senior Notes are unsecured, unsubordinated obligations and rank pari passu in right of payment with KCSM’s existing and future unsecured, unsubordinated obligations. KCSM used a portion of the net proceeds from the offering to repay all amounts outstanding under the unsecured credit agreement dated June 14, 2007 (the “2007 Credit Agreement”). Upon repayment of the outstanding amounts, KCSM terminated its 2007 Credit Agreement, effective March 30, 2009. The 121/2% 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, KCSM may redeem up to 35% of the notes any time prior to April 1, 2012 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 121/2% Senior Notes include certain covenants that restrict or prohibit certain actions.

 

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 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 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 tender offer. The 8.0% Senior Notes are redeemable at KCSM’s option, in whole at any time 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 include certain covenants that restrict or prohibit certain actions.

 

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 the 8.0% Senior Notes. Additionally, on February 1, 2010, the Company repurchased $6.3 million of the 93/8% Senior Notes. The remaining 93/8% Senior Notes mature on May 1, 2012 and are redeemable by KCSM at its option. KCSM recorded debt retirement costs of $14.9 million in the first quarter of 2010.

 

Cash Flow Information

 

Summary cash flow data follows (in millions):

 

 

Net operating cash flows for 2009 decreased $18.4 million to $142.5 million. The decrease in operating cash flows was primarily a result of lower net income from reduced carload/unit volumes due to the downturn in the economy. Net investing cash outflows were $150.4 million and $231.2 million during 2009 and 2008, respectively. This $80.8 million decrease was primarily due to a reduced capital program in response to decreased operating cash flows. Additional information regarding capital expenditures is provided below. Financing cash inflows decreased $30.7 million. During 2009 the Company declared and paid capital reductions to the Company’s shareholders and repaid of borrowings under the 2007 Credit Agreement. In addition the Company received proceeds of $189.0 million from the issuance of the 121/2% Senior Notes and proceeds of $21.6 million from a borrowing from a wholly-owned subsidiary of KCS.

 

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 equipment acquisition.

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

 

 

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. KCSM’s minimum investment obligations for the remaining three years of the current business plan are as follows: $121.0 million, $126.0 million and $132.0 million for 2010, 2011 and 2012, respectively.

 

 

KCSM utilizes various financial instruments that have certain inherent market risks, but these instruments have not been entered into for trading purposes. The following information describes the key aspects of certain financial instruments that have market risk to KCSM.

 

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 and credit quality. The fair value of the Company’s debt was $1,170.0 million and $830.1 million at December 30, 2009 and December 31, 2008, respectively. The financial statement carrying value was $1,136.1 million and $958.4 million at December 30, 2009 and December 31, 2008, respectively.

 

Foreign Exchange Sensitivity.  KCSM uses the dollar as its functional currency. The Company’s results of operations reflect revaluation gains and losses that KCSM records in the process of remeasuring certain transactions from pesos to dollars. Therefore, the Company has exposure to fluctuations in the value of the peso. KCSM manages this risk by monitoring its peso denominated cash inflows and outflows. For example, a hypothetical 10% increase in the U.S. dollar to the Mexican pesos exchange rate on net peso denominated monetary assets of Ps.521.8 million would result in a loss of approximately $3.6 million, and a 10% decrease in the exchange rate would result in a gain of approximately $4.4 million.

 

Inflation risk.  U.S. generally accepted accounting principles require 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 greater than the amounts reported under the historical cost basis.

 

Index to Consolidated Financial Statements

 

 

 

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 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, 2009, 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, 2009, 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. Management’s report was not subject to attestation by the Company’s independent registered public accounting firm pursuant to the temporary rules of the Securities and Exchange Commission that permit the Company to provide only management’s report in this annual report.

 

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, 2009 and 2008 and the related consolidated statements of income, changes in stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2009. 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 consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, 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, 2009 and 2008, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2009, in conformity with U.S. generally accepted accounting principles.

 

 

Kansas City, Missouri

February 11, 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

 

Consolidated Statements of Changes in Stockholders’ Equity and Comprehensive Income

 

 

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 US dollars ($) or millions of Mexican pesos (Ps))

 

 

Kansas City Southern de México, S.A. de C.V. (“KCSM” or the “Company”), was established by the Mexican government in November 1996 in connection with the privatization of the Mexican rail system, which had previously been operated by Ferrocarriles Nacionales de México (“FNM”). In December 1996, Grupo KCSM, S.A. de C.V. (“Grupo KCSM”), (formerly known as Grupo Transportacion Ferroviaria Mexicana, S.A. de C.V.) was awarded the right to acquire an 80% interest in KCSM, pursuant to a stock purchase agreement (the “Acquisition”).

 

KCSM rail lines form a strategically important rail link within Mexico and to the North American Free Trade Agreement (“NAFTA”) corridor. KCSM lines directly link Mexico City and Monterrey (as well as Guadalajara through trackage rights) with the ports of Lazaro Cardenas, Veracruz (through trackage rights granted by Ferrosur, S.A. de C.V. (“Ferrosur”) under the concession) and Tampico and the Mexican/United States border crossings of Nuevo Laredo, Tamaulipas and Laredo, Texas and Matamoros, Tamaulipas and Brownsville, Texas.

 

Arrendadora KCSM, S. de R.L. de C.V. (“Arrendadora KCSM”), a wholly-owned subsidiary, was incorporated on September 27, 2002 as a sociedad anonima de capital variable (variable capital corporation), under the Laws of Mexico and its only operation is the leasing of railroad equipment. On December 7, 2007 after the Company received shareholder approval, Arrendadora KCSM amended its by-laws to transform Arrendadora KCSM into a sociedad de responsabilidad limitada de capital variable, or S. de R.L. de C.V. (limited liability corporation).

 

KCSM Servicios, S.A. de C.V. (“KCSM Servicios”), was incorporated on July 3, 2006, as a sociedad anónima de capital variable (variable capital corporation), under the laws of Mexico. Currently, KCSM Servicios does not have any operations. Ninety-eight percent of the capital stock of KCSM Servicios is owned by KCSM and the remaining two percent is owned by Nafta Rail, S.A. de C.V. (“Nafta Rail”).

 

KCSM Internacional, S.A. de C.V. (“KCSM Internacional”), was incorporated on July 3, 2006, as a sociedad anónima de capital variable (variable capital corporation), under the laws of Mexico. Currently, KCSM Internacional does not have any operations. Ninety-eight percent of the capital stock of KCSM Internacional is owned by KCSM and the remaining two percent is owned by Nafta Rail.

 

KCSM Holdings LLC (“KCSM Holdings”), was formed on December 11, 2006 as a limited liability company under the laws of the state of Delaware. Currently, KCSM Holdings owns ten shares of KCSM’s variable class II stock. KCSM owns one hundred percent of the interest of KCSM Holdings.

 

Mexrail, Inc. (“Mexrail”), owns 100% of The Texas Mexican Railway Company (“Tex-Mex”) which owns a 157-mile rail line extending from Laredo to the port city of Corpus Christi, Texas. Mexrail also owns the northern half of the rail bridge at Laredo, Texas, which spans the Rio Grande River between Mexico and the U.S. KCSM owns 49% of the outstanding capital stock of Mexrail and Kansas City Southern (“KCS”) owns the remaining 51% of Mexrail’s outstanding capital stock. For the years ended December 31, 2009, 2008 and 2007, KCSM recognized its 49% interest under the equity method of accounting and has included in its income statement $1.6 million, $2.7 million and $2.8 million of income, respectively.

 

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.

 

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

 

Notes to Consolidated Financial Statements — (Continued)

 

For the years ended December 31, 2009, 2008 and 2007, KCSM recognized its 25% interest under the equity method of accounting and has included in its income statement $1.3 million, $4.7 million and $2.9 million of income, respectively, attributable to its interest in FTVM. In 2009 and 2008, KCSM received cash dividends of $3.0 million and $7.2 million, respectively, from FTVM.

 

The Concession.  KCSM holds a Concession (“the Concession”) from the Mexican government until June 2047 (exclusive through 2027, subject to certain trackage and haulage rights granted to other concessionaires) which is renewable under certain conditions for additional periods 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 is 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 1.25% of such revenues during the remainder of the period.

 

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 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. KCSM filed its third business plan with the Mexican government in December 2007 in which KCSM committed to certain minimal 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. The Mexican government will have the right to cause KCSM 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 Mexican government must exercise this right within four months after revocation of the Concession. In addition, the Mexican government will 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.

 

Employees and Labor Relations.  KCSM 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

 

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

 

Notes to Consolidated Financial Statements — (Continued)

 

República Mexicana (Mexican Railroad Union), for a term of 50 years, for the purpose of regulating the relationship between the parties and improving conditions for the union employees. Approximately 80% of KCSM’s 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 terms are renegotiated every two years. In June of 2009, the negotiation of the compensation terms and all other benefits was started with the Mexican Railroad Union. The anticipated resolutions of these negotiations are not expected to have a material impact to the consolidated financial statements. The union labor negotiation with the Mexican Railroad Union has not historically resulted in disruption in KCSM’s business operations.

 

 

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.

 

Basis of 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 has been revised to present capital expenditures on a cash basis for the year ended December 31, 2008. This revision did not impact the change in cash and cash equivalents as previously reported, however, net cash provided by operating activities decreased by $34.7 million from $195.6 million to $160.9 million and capital expenditures and cash used by investing activities decreased by $34.7 million from $265.9 million to $231.2 million for the year ended December 31, 2008. The revision did not impact operating income or net income and working capital as previously reported. This revision was not material to net cash provided by operating activities, capital expenditures and net cash used by investing activities for the year ended December 31, 2007.

 

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, environmental remediation, casualty claims, and deferred taxes. Changes in facts and circumstances may result in revised estimates. Actual results could differ from those estimates.

 

Segments.  KCSM is organized as one business segment (railway) and currently operates in one geographical segment (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.

 

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

 

Notes to Consolidated Financial Statements — (Continued)

 

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. Non-monetary assets or liabilities and capital stock transactions originally denominated in Mexican pesos are remeasured into U.S. dollars using the historical exchange rate at the date of the transaction. Depreciation and amortization of non-monetary assets are recorded using the historical cost in U.S. dollars. For tax purposes, KCSM and its subsidiaries are required to maintain their books and records in Mexican pesos.

 

Cash and Cash Equivalents.  Short-term liquid investments with an initial maturity of three months or less when purchased 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, 2009 and 2008, the allowance for doubtful accounts was $0.8 million and $1.7 million, respectively.

 

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 the lower of average cost or market.

 

Derivative Instruments.  Derivatives are measured at fair value and recorded on the balance sheet as either assets or liabilities value. 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. Property and equipment is carried at cost and is depreciated on a straight-line basis over their estimated service lives measured in years. Expenditures that significantly increase asset values or extend useful lives are capitalized. Repair and maintenance costs are expensed as incurred.

 

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 over the lesser of the current expected Concession term, including probable renewal, or the estimated useful lives of the assets and rights.

 

KCSM follows the group method of depreciation which applies a composite rate to classes of similar assets rather than to individual assets. Composite depreciation rates are based upon estimates of the expected average service lives of assets as well as expected salvage value at the end of their useful lives. The estimated average service lives of assets and salvage values are determined through periodic depreciation studies. Depreciation rate studies are performed every three years for equipment and every six years for road property (rail, ties, ballast, etc.). The depreciation studies take into account factors such as:

 

 

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

 

Notes to Consolidated Financial Statements — (Continued)

 

 

 

Also under the group method of depreciation, the cost of railroad property and equipment (net of salvage) retired or replaced in the normal course of business is charged to accumulated depreciation with no gain or loss recognized. Gains or losses on dispositions of land or non-railroad 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 service 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 revaluate the estimated useful life of the impacted asset class.

 

During the year ended December 31, 2009, KCSM engaged an engineering firm to assist management in performing a depreciation study on equipment as well as to assess the adequacy of the accumulated reserves for road property. The results of the study determined that overall KCSM’s depreciation rates should be lowered to better reflect asset usage and replacement patterns. This change in accounting estimate was implemented effective January 1, 2009. The full year reduction of depreciation expense in 2009 resulting from the change in depreciation and amortization rates was $1.9 million.

 

During the fourth quarter of 2009, KCSM changed its useful life estimates for its concession assets. Previously the Company had limited the remaining life estimates to the current Concession term which ends in 2047. However, in consideration of KCSM’s experience in operating under the Concession, the Company determined that it was probable that KCSM will be able to extend the Concession rights for one 50-year term. Based on this, the Company began amortizing the concession assets over the lesser of the current expected Concession term, including probable renewal, or the estimated useful lives of the assets. This change in accounting estimate was implemented prospectively effective October 1, 2009, reducing amortization expense in the fourth quarter by $2.6 million. The estimated remaining lives of KCSM’s concession assets will continue to be reviewed in relation to KCSM’s experience in operating under the Concession.

 

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 is reduced to the estimated fair value.

 

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 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 and credit quality. The fair value of the Company’s debt was $1,170.0 million and $830.1 million at December 31, 2009 and 2008, respectively. The financial statement carrying value was $1,136.1 million and $958.4 million at December 31, 2009 and 2008, respectively.

 

Post-Employment Benefits.  Mexican law requires that the Company provide certain post-employment benefits to its Mexican union and non-union employees. These plans provide statutorily calculated benefits which are payable upon retirement, death, disability, voluntary or involuntary termination to employees who meet applicable service requirements. In addition to these statutorily required post-employment benefits, the Company and the union have been engaged in negotiations regarding an incremental benefit that would be paid to the Company’s union employees upon retirement. Actuaries assist the Company in measuring the Company’s benefit obligation and the cost based upon the current plan provisions, employee demographics

 

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

 

Notes to Consolidated Financial Statements — (Continued)

 

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 statement of income.

 

Employees’ Statutory Profit Sharing.  KCSM is subject to employee statutory profit sharing requirements under Mexican law and calculates profit sharing liability as 10% of KCSM net taxable income, adjusted as prescribed by the Mexican income tax law. Deferred employee statutory profit sharing is accounted for in a manner similar to income taxes included as a component of compensation and benefits within the consolidated statement of income.

 

Income Taxes.  Deferred income tax effects of transactions reported in different periods for financial reporting and income tax 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 upon enactment.

 

KCSM has recognized a deferred tax asset, net of a valuation allowance for net operating loss carryovers. KCSM 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.

 

 

In June of 2009, the Financial Accounting Standards Board (“FASB”) approved the “FASB Accounting Standards Codification” (the “FASB ASC”) to become the single source of authoritative U.S. GAAP (other than guidance issued by the SEC) superseding all then-existing non-SEC accounting and reporting standards. The FASB ASC does not change current U.S. GAAP, but is intended to simplify user access to all authoritative U.S. GAAP through the introduction of a new structure providing all authoritative literature by topic in one place.

 

In December of 2009, the FASB issued 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 statement 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. This standard is effective for the Company beginning on January 1, 2010. The Company expects the adoption of this standard will not have an impact on the Company’s results of operations and financial condition.

 

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

 

Notes to Consolidated Financial Statements — (Continued)

 

 

 

Property and Equipment.  Property and equipment, including concession assets, and related accumulated depreciation and amortization are summarized below at December 31 (in millions):

 

 

Concession assets, net of accumulated amortization of $259.8 million and $254.3 million, totaled $1,774.2 million and $1,775.2 million for 2009 and 2008, respectively.

 

Depreciation and amortization of property and equipment totaled $102.4 million, $103.2 million, and $96.1 million for 2009, 2008, and 2007, respectively.

 

 

Other Current Assets.  Other current assets 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)

 

Accounts Payable and Accrued Liabilities.  Accounts payable and accrued liabilities included the following items at December 31 (in millions):

 

 

 

Long-term debt follows at December 31 (in millions):

 

 

Revolving Credit Facility and Term Loan.  On June 14, 2007, KCSM entered into a new unsecured credit agreement (the “2007 Credit Agreement”) in an aggregate amount of up to $111.0 million, consisting of a revolving credit facility of up to $81.0 million, and a term loan facility of $30.0 million with Bank of America, N.A., BBVA Bancomer, S.A., Institución de Banca Múltiple, and the other lenders named in the 2007 Credit Agreement. On March 30, 2009, KCSM used a portion of the net proceeds from the $200.0 million 121/2% senior unsecured notes due April 1, 2016 (the “121/2% Senior Notes”) offering to repay all amounts outstanding under the 2007 KCSM Credit Agreement. Upon repayment of the outstanding amounts, KCSM terminated the 2007 Credit Agreement.

 

93/8% Senior Notes.  On April 19, 2005, KCSM issued $460.0 million principal amount of 93/8% senior unsecured notes due May 1, 2012 (the “93/8% Senior Notes”), which bear interest semiannually at a fixed annual rate of 93/8%. The 93/8% Senior Notes are redeemable at KCSM’s option in whole or in part on or after May 1, 2009, subject to certain limitations, at the following redemption prices (expressed in percentages of principal amount), plus any accrued and unpaid interest: 2009 — 104.688%, 2010 — 102.344% and thereafter — 100.000%.