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KANSAS CITY SOUTHERN DE MEXICO, S.A. DE C.V. - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations

January 31, 2014

The following is a discussion of KCSM's results of operations, certain changes in its financial position, liquidity, capital structure and business developments for the periods covered by the consolidated financial statements included under Item 8 of this Form 10-K. This discussion should be read in conjunction with the included consolidated financial statements, the related notes, and other information included in this report. Certain prior year amounts have been reclassified to conform to the current year presentation. CAUTIONARY INFORMATION The discussions set forth in this Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. In addition, management may make forward-looking statements orally or in other writings, including, but not limited to, in press releases, executive presentations and in other filings with the Securities and Exchange Commission . Readers can identify these forward-looking statements by the use of such verbs as "expects," "anticipates," "believes" or similar verbs or conjugations of such verbs. These statements involve a number of risks and uncertainties. Actual results could materially differ from those anticipated by such forward-looking statements. Such differences could be caused by a number of factors or combination of factors including, but not limited to, those discussed under Item 1A of this Form 10-K, "Risk Factors." Readers are strongly encouraged to consider these factors when evaluating any forward-looking statements concerning the Company. EXECUTIVE SUMMARY 2013 Financial Overview In 2013, KCSM generated record-high revenues and volumes. Revenues of $1.1 billion were driven by strong growth in intermodal and automotive business units. In 2013, revenues increased 8% over 2012, as a result of positive pricing impacts, increased fuel surcharge and the strengthening of the Mexican peso against the U.S. dollar. All business units other than agriculture and minerals experienced revenue growth, as the Company's diverse commodity mix provided stability and allowed for overall revenue growth as markets shifted during the year. Agriculture and minerals revenues decreased due lower grain production as severe drought conditions experienced in the Midwest region of the United States affected grain volumes in the second half of 2012 through the first half of 2013. Operating expenses increased 14% during 2013, compared to 2012, as a result of a $43.0 million net reduction to operating expense in 2012 due to the elimination of a deferred statutory profit sharing liability as a result of the organizational restructuring. In addition, operating expenses increased due to higher fuel prices, depreciation and amortization expense and the strengthening of the Mexican peso against the U.S. dollar. The Company's continued focus on operating expense control resulted in operating expenses as a percentage of revenues of 64.1%. 16 -------------------------------------------------------------------------------- Table of Contents KCSM's revenues and operating expenses are affected by fluctuations in the value of the Mexican peso against the U.S. dollar. Based on the volume of revenue and expense transactions denominated in pesos, revenue and expense fluctuations generally offset, with insignificant net impacts to operating income. The Company reported consolidated net income of $142.0 million for the year ended December 31, 2013 , compared to $191.2 million for 2012. The Company received investment grade credit ratings during late 2012 and early 2013 as a result of several factors, including improved financial strength and flexibility resulting from lengthened debt maturities, increased liquidity and reduced interest expense. This improved credit profile allowed the Company to refinance a significant portion of its existing debt in 2013 at lower interest rates and longer debt maturities. These efforts contributed to the $27.2 million reduction in interest expense for the year ended December 31, 2013 , as compared to the prior year. As a result of refinancing activities, the Company recognized debt retirement costs of $117.7 million during 2013, compared to $0.5 million in 2012. In 2013, the Company invested $159.7 million in capital expenditures and $80.9 million for the purchase and replacement of equipment under operating leases. During the fourth quarter of 2013, the Company initiated a multi-year lease conversion program (the "Lease Conversion Program") to optimize the Company's capital structure and take advantage of a favorable interest rate environment. As part of the Lease Conversion Program, beginning late in the fourth quarter of 2013, the Company will purchase certain equipment under existing operating leases and will purchase replacement equipment as certain operating leases expire. This initiative will be funded with a portion of the proceeds from the floating rate senior notes issued during the fourth quarter of 2013. This initiative is expected to benefit the Company through reduced equipment costs, partially offset by increased depreciation and interest expense. As a result of purchasing certain equipment under existing operating leases, the Company expects to incur lease termination costs (included in operating expenses) of approximately $15.0 million as the Company enters into binding agreements with certain lessors during the first quarter of 2014. RESULTS OF OPERATIONS Year Ended December 31, 2013 , compared to the Year Ended December 31, 2012 The following summarizes KCSM's consolidated income statement components (in millions): Change 2013 2012 Dollars Revenues $ 1,101.0 $ 1,021.7 $ 79.3 Operating expenses 705.3 618.0 87.3 Operating income 395.7 403.7 (8.0 ) Equity in net earnings of unconsolidated affiliate 3.2 3.2 - Interest expense (61.2 ) (88.4 ) 27.2 Debt retirement costs (117.7 ) (0.5 ) (117.2 ) Foreign exchange gain (loss) (1.2 ) 3.0 (4.2 ) Other expense, net (0.4 ) (0.2 ) (0.2 ) Income before income taxes 218.4 320.8 (102.4 ) Income tax expense 76.4 129.6 (53.2 ) Net income $ 142.0 $ 191.2 $ (49.2 ) 17 -------------------------------------------------------------------------------- Table of Contents Revenues The following summarizes revenues (in millions), carload/unit statistics (in thousands) and revenue per carload/unit: Revenues Carloads and Units Revenue per Carload/Unit 2013 2012 % Change 2013 2012 % Change 2013 2012 % Change Chemical and petroleum $ 207.4 $ 193.6 7 % 96.0 99.1 (3 )% $ 2,160 $ 1,954 11 % Industrial and consumer products 262.7 247.6 6 % 166.7 167.7 (1 )% 1,576 1,476 7 % Agriculture and minerals 166.6 184.6 (10 )% 89.8 100.4 (11 )% 1,855 1,839 1 % Energy 30.9 28.0 10 % 29.4 28.8 2 % 1,051 972 8 % Intermodal 227.6 191.3 19 % 505.4 484.5 4 % 450 395 14 % Automotive 183.8 158.5 16 % 97.7 91.9 6 % 1,881 1,725 9 % Carload revenues, carloads and units 1,079.0 1,003.6 8 % 985.0 972.4 1 % $ 1,095 $ 1,032 6 % Other revenue 22.0 18.1 22 % Total revenues (i) $ 1,101.0 $ 1,021.7 8 % (i) Included in revenues: Fuel surcharge $ 177.3 $ 146.5 Freight revenues include both revenue for transportation services and fuel surcharges. For the year ended December 31, 2013 , revenues and carload/unit volumes increased 8% and 1%, respectively, compared to 2012, driven by strong growth in intermodal and automotive. Agriculture and minerals revenues decreased $18.0 million for the year ended December 31, 2013 , due to an 11% reduction in grain volumes as the severe drought conditions experienced in the Midwestern region of the United States affected grain volumes in the second half of 2012 through the first half of 2013. Revenue per carload/unit increased by 6% for the year ended December 31, 2013 , compared to 2012, due to positive pricing impacts, fuel surcharge and the strengthening of the Mexican Peso against the U.S. dollar. KCSM's fuel surcharge is a mechanism to adjust revenue based upon changing fuel prices. Fuel surcharge is calculated using a fuel price from a prior time period that can be up to 60 days earlier. In a period of volatile fuel prices or changing customer business mix, changes in fuel expense and fuel surcharge may differ. The following discussion provides an analysis of revenues by commodity group: Revenues by commodity group for 2013 Chemical and petroleum. Revenues increased [[Image Removed]] $13.8 million for the year ended December 31, 2013 , compared to 2012, due to an 11% increase in revenue per carload/unit, partially offset by a 3% decrease in carload/unit volumes. Revenues increased due to positive pricing impacts for petroleum and plastics. Petroleum volumes decreased in the second half of the year due to a customer's temporary route change and increased reliance on hydro power. 18 -------------------------------------------------------------------------------- Table of Contents Revenues by commodity group for 2013 Industrial and consumer products. Revenues [[Image Removed]] increased $15.1 million for the year ended December 31, 2013 , compared to 2012, due to a 7% increase in revenue per carload/unit, partially offset by a 1% decrease in carload/unit volumes. Metals and scrap revenues increased due to a longer average length of haul, partially offset by lower building material volumes due to high inventory levels and slowing economic conditions and a decrease in other volumes as a result of lost business. Agriculture and mineral. Revenues decreased $18.0 million for the year ended December 31, 2013 , compared to 2012, due to an 11% decrease in carload/unit volumes. Grain volumes and average length of haul decreased in the second half of 2012 through the first half of 2013 as a result of the severe [[Image Removed]] drought conditions experienced in the Midwestern region of the United States during 2012. Food products volumes decreased during 2013 as higher dried distillers grain prices for imports from the United States drove a product substitution in Mexico . Energy. Revenues increased $2.9 million for the year ended December 31, 2013 , compared to 2012, due to an 8% increase in revenue per carload/unit and a 2% increase in [[Image Removed]] carload/unit volumes. The volume increase was driven by higher demand for pet coke used in cement for highway projects. Intermodal. Revenues increased $36.3 million for the year ended December 31, 2013 , compared to 2012, due to a 14% increase in revenue per carload/unit and a 4% increase in carload/unit volumes. Revenue per carload/unit increased as a result of cross border length of haul and volume growth was driven by conversion of cross border general commodity truck traffic to rail. Automotive. Revenues increased $25.3 million for the year ended December 31, 2013 , compared to 2012, due to a 9% increase in revenue per carload/unit and a 6% increase in carload/unit volumes. Growth was driven by new business, strong year-over-year growth in North American automobile sales for Original Equipment Manufacturers and increased import/export volume through the Port of Lazaro Cardenas . Operating Expenses Operating expenses, as shown below (in millions), increased $87.3 million for the year ended December 31, 2013 , when compared to 2012, due to the elimination of $43.0 million of deferred statutory profit sharing liability in 2012 as a result of the organizational restructuring, higher fuel prices, an increase in depreciation and amortization expense and the strengthening of the Mexican peso against the U.S. dollar. As a result of the organizational restructuring in 2012, KCSM pays KCSM Servicios, a wholly-owned subsidiary of KCS, market-based rates for employee services. This market-based rate was determined by applying a percentage mark-up to amounts paid by KCSM Servicios to its employees and vendors. For comparative purposes, amounts paid to KCSM Servicios are classified according to the nature of the services provided to KCSM and the percentage mark-up portion of payments to KCSM Servicios is included within materials and other expense. 19 -------------------------------------------------------------------------------- Table of Contents Change 2013 2012 Dollars Percent Compensation and benefits $ 123.0 $ 124.0 $ (1.0 ) (1 )% Purchased services 144.6 144.6 - - Fuel 186.4 164.1 22.3 14 % Equipment costs 82.4 77.9 4.5 6 % Depreciation and amortization 102.7 91.3 11.4 12 % Materials and other 66.2 59.1 7.1 12 % Elimination of deferred statutory profit sharing liability, net - (43.0 ) 43.0 100 % Total operating expenses $ 705.3 $ 618.0 $ 87.3 14 % Compensation and benefits. Compensation and benefits decreased $1.0 million for the year ended December 31, 2013 , compared to 2012, due to a $7.3 million reduction in deferred statutory profit sharing expense as a result of the organizational restructuring in 2012, partially offset by annual salary and benefits rate increases and the strengthening of the Mexican peso against the U.S. dollar. Purchased services. Purchased services expense was flat for the year ended December 31, 2013 , compared to 2012, due to a reduction in track and equipment maintenance expenses, offset by an increase in security services and corporate expenses. Track maintenance expense decreased due to the termination of a maintenance contract as a result of in-sourcing of certain maintenance activities. Fuel. Fuel expense increased $22.3 million for the year ended December 31, 2013 , compared to 2012, due to higher diesel fuel prices as the average price per gallon, including the effects of the strengthening of the Mexican peso against the U.S. dollar, was $2.98 in 2013, compared to $2.59 in 2012. Equipment costs. Equipment costs increased $4.5 million for the year ended December 31, 2013 , compared to 2012, due to an increase in the use of other railroads' freight cars. This increase was partially offset by the decrease in locomotive lease expense as a result of the purchase of 30 locomotives in June of 2013, which were previously leased by the Company under an operating lease agreement. As a result of reduced lease expense from the locomotive lease conversion and the 2014 activity under the Lease Conversion Program, offset by expected carload/unit volume growth, total equipment costs are expected to decrease by approximately 5%-10% for the year ended December 31, 2014 , as compared to the same period in 2013. In addition, the Company expects to incur lease termination costs of approximately $15.0 million in the first quarter of 2014 for the purchase of certain equipment under existing operating leases. Depreciation and amortization. Depreciation and amortization expense increased $11.4 million for the year ended December 31, 2013 , compared to 2012, due to a larger asset base, including the purchase of 30 locomotives in June 2013 , which were previously leased by the Company under an operating lease agreement. As a result of expected capital expenditures, the locomotive lease conversion and the 2014 asset acquisitions under the Lease Conversion Program, total depreciation and amortization expense is expected to increase by approximately 5%-10% for the year ended December 31, 2014 , as compared to the same period in 2013. Materials and other. Materials and other expense increased $7.1 million for the year ended December 31, 2013 , compared to 2012, due to a $4.9 million increase in concession duty expense. KCSM paid concession duty expense of 0.5% of gross revenues for the first 15 years of the Concession period and on June 24, 2012 , KCSM began paying 1.25% of gross revenues, which is effective for the remaining years of the Concession. In addition, materials and other expense increased due to increases in casualty expense and the percentage mark-up paid to KCSM Servicios as a result of the organizational restructuring in the second quarter of 2012. Elimination of deferred statutory profit sharing liability, net. As a result of the organizational restructuring in 2012, KCSM's obligation to pay statutory profit sharing terminated as of May 1, 2012 and accordingly, KCSM recognized a $43.0 million net reduction to operating expense. This reduction includes the elimination of $47.8 million of the deferred statutory profit sharing liability, net of $4.8 million of transaction costs. Non-Operating Expenses 20 -------------------------------------------------------------------------------- Table of Contents Equity in net earnings of unconsolidated affiliates. Equity in earnings from the operations of FTVM was flat for the years ended December 31, 2013 and 2012, respectively. Interest expense. Interest expense decreased $27.2 million for the year ended December 31, 2013 , compared to 2012, due to lower average interest rates as a result of the Company's refinancing activities. For the year ended December 31, 2013 , the average interest rate and the average debt balance were 5.1% and $1,170.9 million , compared to 7.4% and $1,179.3 million , respectively, in 2012. As a result of the financing activities in 2013, interest expense is expected to decrease by approximately $16.3 million for the year ended December 31, 2014 , as compared to 2013. Debt retirement costs. Debt retirement costs were $117.7 million and $0.5 million for the years ended December 31, 2013 and 2012, respectively, related to the tender and call premiums, original issue discounts and write-off of unamortized debt issuance costs associated with the various debt refinancing and redemption activities. Foreign exchange gain (loss). For the years ended December 31, 2013 , foreign exchange loss was $1.2 million , compared to a foreign exchange gain of $3.0 million in 2012. Foreign exchange gain (loss) includes the re-measurement and settlement of monetary assets and liabilities denominated in Mexican pesos and the gain (loss) on foreign currency forward contracts. For the years ended December 31, 2013 and 2012, the re-measurement and settlement of monetary assets and liabilities denominated in Mexican pesos resulted in a foreign exchange loss of $0.5 million , compared to a foreign exchange gain of $3.0 million , respectively. During 2013, the Company entered into foreign currency forward contracts to hedge its net exposure to fluctuations in its cash tax obligation due to changes in the value of the Mexican peso against the U.S. dollar. During the first half of 2013, the Company entered into foreign currency forward contracts maturing on December 31, 2013 , with an aggregate notional amount of $325.0 million and a weighted average exchange rate of Ps.12.93 to each U.S. dollar. In December 2013 , the Company settled these contracts by entering into offsetting foreign currency forward contracts with an aggregate notional amount of $324.3 million and a weighted average exchange rate of Ps.12.96 to each U.S. dollar. As a result of these transactions, the Company recognized a net foreign exchange loss of $0.7 million for the year ended December 31, 2013 . Other expense, net. Other expense, net increased $0.2 million for the year ended December 31, 2013 , compared to 2012, due to lower miscellaneous income. Income tax expense. Income tax expense decreased $53.2 million for the year ended December 31, 2013 , compared to 2012, due to lower pre-tax income and a lower effective tax rate. The effective income tax rate was 35.0% and 40.4% for the years ended December 31, 2013 and 2012, respectively. The decrease in the effective tax rate was due to a slight weakening of the Mexican peso against the U.S. dollar in 2013 compared to the strengthening of the Mexican peso against the U.S. dollar in 2012. These rates were also affected by the reversal in 2013 of a previously recognized benefit as a result of a court ruling, an increase in the Mexico tax rate, and higher inflation in 2012. Further information on the components of the effective tax rates for the years ended December 31, 2013 and 2012, is presented in Item 8, "Financial Statements and Supplementary Data - Note 8 Income Taxes." LIQUIDITY AND CAPITAL RESOURCES Overview The Company focuses its cash and capital resources on optimizing its capital structure and investing in the business. In late 2012 and early 2013, the Company received investment grade credit ratings as a result of several factors, including improved financial strength and flexibility resulting from lengthened debt maturities, increased liquidity and reduced interest expense. This improved credit profile allowed the Company to refinance a significant portion of its existing debt at lower interest rates and longer maturities in 2013. During the fourth quarter of 2013, the Company initiated the Lease Conversion Program to optimize the Company's capital structure and take advantage of a favorable interest rate environment. As part of the Lease Conversion Program, beginning late in the fourth quarter of 2013, the Company will purchase certain equipment under existing operating leases and will purchase replacement equipment as certain operating leases expire. During the fourth quarter of 2013, KCSM issued $250 million aggregate principal amount of floating rate senior notes, with a portion of the proceeds to be used to fund the purchase of equipment under the Lease Conversion Program. 21 -------------------------------------------------------------------------------- Table of Contents In 2013, the Company invested $159.7 million in capital expenditures and $80.9 million for the purchase or replacement of equipment under operating leases. On December 31, 2013 , total available liquidity (the unrestricted cash balance plus revolving credit facility availability) was $424.8 million , compared to available liquidity at December 31, 2012 , of $209.2 million . The increase in total available liquidity in 2013, compared to 2012, was a result of the proceeds received from the floating rate senior notes as previously described. In January 2014 , the Company amended the 2012 Credit Agreement to eliminate certain representations as a condition to borrowing under the revolving facility. In addition, the Company established a $200.0 million commercial paper program (the "Commercial Paper Program"). The Company's revolving facility will serve as a backstop for the Commercial Paper Program. This Commercial Paper Program is expected to serve as KCSM's primary means of short-term funding in the future. Though KCSM's cash flows from operations are sufficient to fund operations, capital expenditures and debt service, the Company may, from time to time, incur debt to refinance existing indebtedness, purchase equipment under operating leases, or to fund equipment additions or new investments. 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 expenses, capital expenditures, debt service costs and other commitments in the foreseeable future. The Company's current financing instruments contain restrictive covenants which limit or preclude certain actions; however, the covenants are structured such that the Company has sufficient flexibility to conduct its operations. The Company was in compliance with all of its debt covenants as of December 31, 2013 . 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 were to experience a reduction in revenues or a substantial increase in operating costs or other liabilities, its earnings could be significantly reduced, increasing the risk of non-compliance with debt covenants. Additionally, KCSM is subject to external factors impacting debt and capital markets and its ability to obtain financing under reasonable terms is subject to market conditions. Volatility in capital markets and the tightening of market liquidity could impact KCSM's access to capital. Further, KCSM's cost of debt can be impacted by independent rating agencies, which assign debt ratings based on certain factors including credit measurements such as interest coverage and leverage ratios, liquidity and competitive position. Three credit rating agencies provide their views of the Company's outlook and ratings. S&P rates the senior unsecured debt and corporate credit of KCSM as investment grade. Moody's rates KCSM's senior unsecured debt as investment grade. Fitch has assigned an investment grade Issuer Default Rating to KCSM and rates the senior unsecured debt as investment grade. Ratings and outlooks change from time to time and can be found on the websites of S&P, Moody's and Fitch. Cash Flow Information The following table summarizes cash flow data for the years ended December 31, 2013 and 2012 (in millions): 2013 2012 Cash flows provided by (used for): Operating activities $ 461.5 $ 277.1 Investing activities (238.2 ) (205.3 ) Financing activities (7.7 ) (78.3 ) Net increase (decrease) in cash and cash equivalents 215.6 (6.5 ) Cash and cash equivalents beginning of year 9.2 15.7 Cash and cash equivalents end of year $ 224.8 $ 9.2 During 2013, cash and cash equivalents increased $215.6 million due to an increase in borrowings that will be used, in part, to fund the purchase or replacement of certain equipment under the Lease Conversion Program. In addition, increased cash flows from operating activities were used to fund investing activities, and to refinance and reduce outstanding debt. Operating Cash Flows. Net operating cash flows for 2013 increased $184.4 million to $461.5 million due to increased revenues and an increase in cash provided by changes in working capital items, resulting mainly from the timing of certain payments and receipts. 22 -------------------------------------------------------------------------------- Table of Contents Investing Cash Flows. Net investing cash outflows were $238.2 million and $205.3 million during 2013 and 2012, respectively. This $32.9 million increase was due to the purchase or replacement of equipment under operating leases. Financing Cash Flows. Financing cash inflows are generated from the issuance of long-term debt and proceeds from related company debt. Financing cash outflows are used for the repayment of debt, related company debt, the payment of dividends and the payment of debt costs. Financing cash flows for 2013 and 2012 are discussed in more detail below: Net financing cash outflows for 2013 were $7.7 million . During 2013, the Company repaid $997.2 million of outstanding debt, repaid $181.4 million of related company debt and paid $110.3 million in debt costs. In addition, the Company paid dividends of $19.1 million . The Company received net proceeds of $1,230.8 million from the issuance of long-term debt and borrowings under the revolving credit facility, and $69.5 million in proceeds from a related company borrowing. Net financing cash outflows for 2012 were $78.3 million . During 2012, the Company repaid $87.2 million of related company debt, repaid $18.1 million of outstanding debt and paid $0.8 million in debt costs. During the same year, the Company received $18.8 million of proceeds of capital contribution from the Company's shareholders and $9.0 million in proceeds from a borrowing from a wholly-owned subsidiary of KCS. Capital Expenditures KCSM has funded, and expects to continue to fund, capital expenditures with operating cash flows, debt financing and equipment leases. The following table summarizes capital expenditures by type for the years ended December 31, 2013 and 2012 (in millions): 2013 2012 Roadway capital program $ 100.5 $ 110.1 Equipment 21.0 27.5 Locomotive acquisitions - 22.5 Capacity 16.8 22.2 Information technology 7.3 4.1 Other 16.4 7.8 Total capital expenditures (accrual basis) 162.0 194.2 Change in capital accruals (2.3 ) 12.1 Total cash capital expenditures $ 159.7 $ 206.3 Purchase or replacement of equipment under operating leases Locomotive $ 66.6 $ - Equipment 15.7 3.3 Total (accrual basis) 82.3 3.3 Change in capital accruals (1.4 ) - Total cash basis $ 80.9 $ 3.3 Generally, the Company's capital program consists of capital replacement. For 2014, internally generated cash flows are expected to fund cash capital expenditures, which are currently estimated to be between $165.0 million and $185.0 million . Proceeds from the fourth quarter 2013 debt issuance are expected to fund the purchase or replacement of equipment under the Lease Conversion Program, which are currently estimated to be between $90.0 million and $100.0 million in 2014. 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 are as follows: $143.0 million , $148.0 million , $154.0 million and $161.0 million for 2014, 2015, 2016 and 2017, respectively. 23 -------------------------------------------------------------------------------- Table of Contents Property Statistics The following table summarizes certain property statistics as of December 31 : 2013 (i) 2012 Track miles of rail installed 89 86 Cross ties installed 331,672 378,861 ____________________ (i) The decrease in cross ties installed during 2013 compared to 2012, reflects lower maintenance and capacity expansion activities compared to 2012. CRITICAL ACCOUNTING POLICIES AND ESTIMATES KCSM's accounting and financial reporting policies are in conformity with U.S. generally accepted accounting principles ("U.S. GAAP"). The preparation of financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Management believes that the following accounting policies and estimates are critical to an understanding of KCSM's historical and future performance. Management has discussed the development and selection of the following critical accounting estimates with the Audit Committee of KCS's Board of Directors and the Audit Committee has reviewed the selection, application and disclosure of the Company's critical accounting policies and estimates. Capitalization, Depreciation and Amortization of Property and Equipment (including Concession Assets) Due to the highly capital intensive nature of the railroad industry, capitalization and depreciation of property and equipment are a substantial portion of the Company's consolidated financial statements. Net property and equipment, including concession assets, comprised approximately 82% of the Company's total assets as of December 31, 2013 , and related depreciation and amortization comprised approximately 15% of total operating expenses for the year ended December 31, 2013 . KCSM's annual capital expenditures are primarily for capital replacement programs which are generally constructed by employees. KCSM capitalizes costs for self-constructed additions and improvements to property including direct labor and material, indirect overhead costs, and interest during long-term construction projects. Direct costs are charged to capital projects based on the work performed and the material used. Indirect overhead costs are allocated to capital projects as a standard percentage, which is evaluated annually, and applied to direct labor and material costs. Asset removal activities are performed in conjunction with replacement activities; therefore, removal costs are estimated based on a standard percentage of direct labor and indirect overhead costs related to capital replacement projects. For purchased assets, all costs necessary to make the asset ready for its intended use are capitalized. Expenditures that significantly increase asset values, productive capacity, efficiency, safety or extend useful lives are capitalized. Repair and maintenance costs are expensed as incurred. Property and equipment are carried at cost and are depreciated primarily on the group method of depreciation, which the Company believes closely approximates a straight line basis over the estimated useful lives of the assets measured in years. Technology assets and leasehold improvements are depreciated using the straight line method over the lesser of the estimated useful lives of the assets or the lease term. Costs incurred by the Company to acquire the concession rights and related assets, as well as subsequent improvements to the concession assets, are capitalized and amortized using the group method of depreciation over the lesser of the current expected Concession term, including probable renewal of an additional 50-year term, or the estimated useful lives of the assets and rights. The Company's ongoing evaluation of the useful lives of concession assets and rights considers the aggregation of the following facts and circumstances: The Company's executive management is dedicated to ensuring compliance with the various provisions of the Concession and to maintaining positive relationships with the SCT and other Mexican federal, state and municipal governmental authorities; During the time since the Concession was granted, the relationships between KCSM and the various Mexican governmental authorities have matured and the guidelines for operating under the Concession have become more defined with experience; There are no known supportable sanctions or compliance issues that would cause the SCT to revoke the Concession or prevent KCSM from renewing the Concession; and 24 -------------------------------------------------------------------------------- Table of Contents KCSM operations are an integral part of the KCS operations strategy, and related investment analyses and operational decisions assume that the Company's cross border rail business operates into perpetuity, and do not assume that Mexico operations terminate at the end of the current Concession term. Based on the above factors, as of December 31, 2013 , the Company continues to believe that it is probable that the Concession will be renewed for an additional 50-year term beyond the current term. The group method of depreciation applies a composite rate to classes of similar assets rather than to individual assets. Composite depreciation rates are based upon the Company's estimates of the expected average useful lives of assets as well as expected net salvage value at the end of their useful lives. In developing these estimates, the Company utilizes periodic depreciation studies performed by an independent engineering firm. Depreciation rate studies are performed at least every three years for equipment and at least every six years for road property (rail, ties, ballast, etc.). The depreciation studies take into account factors such as: Statistical analysis of historical patterns of use and retirements of each asset class; Evaluation of any expected changes in current operations and the outlook for the continued use of the assets; Evaluation of technological advances and changes to maintenance practices; and Historical and expected salvage to be received upon retirement. The depreciation studies may also indicate that the recorded amount of accumulated depreciation is deficient or in excess of the amount indicated by the study. Any such deficiency or excess is amortized as a component of depreciation expense over the remaining useful lives of the affected asset class, as determined by the study. The Company also monitors these factors in non-study years to determine if adjustments should be made to depreciation rates. Any changes in depreciation rates are implemented prospectively. During the year ended December 31, 2011 , KCSM engaged an independent engineering firm to assist management in performing a depreciation study on its road property and equipment. The depreciation impacts of the study results were immaterial to 2011 consolidated financial results. Also under the group method of depreciation, the cost of railroad property and equipment (net of salvage or sales proceeds) retired or replaced in the normal course of business is charged to accumulated depreciation with no gain or loss recognized. Actual historical costs are retired when available, such as with equipment costs. The use of estimates in recording the retirement of certain roadway assets is necessary as it is impractical to track individual, homogeneous network-type assets. For these types of assets, historical costs are estimated by (1) deflating current costs using inflation indices published by the U.S. Bureau of Labor Statistics and (2) the estimated useful life of the assets as determined by the depreciation studies. The indices applied to the replacement value are selected because they closely correlate with the major costs of the items comprising the roadway assets. Because of the number of estimates inherent in the depreciation and retirement processes and because it is impossible to precisely estimate each of these variables until a group of assets is completely retired, the Company continually monitors the estimated useful lives of its assets and the accumulated depreciation associated with each asset group to ensure the depreciation rates are appropriate. Gains or losses on dispositions of land or non-group property and abnormal retirements of railroad property are recognized through income. A retirement of railroad property would be considered abnormal if the cause of the retirement is unusual in nature and its actual life is significantly shorter than what would be expected for that group based on the depreciation studies. An abnormal retirement could cause the Company to re-evaluate the estimated useful life of the impacted asset class. There were no significant gains or losses from abnormal retirements of property or equipment for any of the three years ended December 31, 2013 . Estimation of the average useful lives of assets and net salvage values require significant management judgment. Estimated average useful lives may vary over time due to changes in physical use, technology, asset strategies and other factors that could have an impact on the retirement experience of the asset classes. Accordingly, changes in the assets' estimated useful lives could significantly impact future periods' depreciation expense. Depreciation and amortization expense for the year ended December 31, 2013 , was $102.7 million . If the weighted average useful lives of assets were changed by one year, annual depreciation and amortization expense would change approximately $3.5 million . 25 -------------------------------------------------------------------------------- Table of Contents Long-lived assets are reviewed for impairment when events or circumstances indicate that the carrying amount of an asset may not be recoverable. If impairment indicators are present and the estimated future undiscounted cash flows are less than the carrying value of the long-lived assets, the carrying value would be reduced to the estimated fair value. Future cash flow estimates for an impairment review would be based on the lowest level of identifiable cash flows. During the years ended December 31, 2013 and 2012, management did not identify any indicators of impairment. Income Taxes Deferred income taxes represent a net asset or liability of the Company. For financial reporting purposes, management determines the current tax liability, as well as deferred tax assets and liabilities, in accordance with the liability method of accounting for income taxes. The provision for income taxes is the sum of income taxes both currently payable and deferred into the future. Currently payable income taxes represent the liability related to the income tax returns for the current year and anticipated tax payments resulting from income tax audits, while the net deferred tax expense or benefit represents the change in the balance of net deferred tax assets or liabilities as reported on the balance sheet. The changes in deferred tax assets and liabilities are determined based upon the estimated timing of reversal of differences between the carrying amount of assets and liabilities for financial reporting purposes and the basis of assets and liabilities for tax purposes as measured using the currently enacted tax rates that will be in effect at the time these differences are expected to reverse. Additionally, management estimates whether taxable operating income in future periods will be sufficient to fully recognize any deferred tax assets. Income tax expense has additional complexities such as the impacts of exchange rate variations and inflation, both of which can have a significant impact on the effective income tax rate. Management believes that the assumptions and estimates related to the provision for income taxes are critical to the Company's results of operations. For the year ended December 31, 2013 , income tax expense totaled $76.4 million . For every 1% change in the 2013 effective rate, income tax expense would have changed by approximately $2.2 million . If the Mexican inflation rate used at the end of 2013 had increased 1%, the effective income tax rate would have increased from 35.0% to 35.1%, and income tax expense would have increased by approximately $0.3 million . For further information on the impact of foreign exchange fluctuation on income taxes, see Item 7A, "Quantitative and Qualitative Disclosures About Market Risks - Foreign Exchange Sensitivity." OTHER MATTERS Inflation. U.S. GAAP requires the use of historical cost, which does not reflect the effects of inflation on the replacement cost of property. Due to the capital intensive nature of the Company's business, the replacement cost of these assets would be significantly higher than the amounts reported under the historical cost basis. Item 7A. Quantitative and Qualitative Disclosures About Market Risks KCSM utilizes various financial instruments that have certain inherent market risks. These instruments have not been entered into for trading purposes. The following information, together with Note 5 to the Consolidated Financial Statements in Item 8 of this Form 10-K, describes the key aspects of certain financial instruments that have market risk to KCSM. Interest Rate Sensitivity. At December 31, 2013 , floating-rate indebtedness was $250.0 million ; the Company did not have floating-rate indebtedness in 2012. The Company's floating rate senior notes bear interest quarterly at a rate equal to the three-month U.S. dollar LIBOR plus 70 basis points per annum. Considering the balance of $250.0 million of variable rate debt at December 31, 2013 , KCSM is sensitive to fluctuations in interest rates. For example, a hypothetical 100 basis points increase in the three-month U.S. dollar LIBOR would result in additional interest expense of $2.5 million on an annualized basis for the floating rate senior notes as of December 31, 2013 . Based upon the borrowing rates available to KCSM for indebtedness with similar terms and average maturities, the fair value of debt, including related company debt, was approximately $1,215.8 million and $1,240.9 million at December 31, 2013 and 2012, respectively, compared with a carrying value of $1,260.4 million and $1,135.1 million at December 31, 2013 and 2012, respectively. 26 -------------------------------------------------------------------------------- Table of Contents Commodity Price Sensitivity. The Company holds fuel inventories for use in operations. These inventories are not material to KCSM's overall financial position. Fuel costs are expected to reflect market conditions in 2014; however, fuel costs are unpredictable and subject to a variety of factors outside the Company's control. Assuming annual consumption of 60 million gallons, a 10 cent change in the price per gallon of fuel would cause a $6.0 million change in operating expenses. KCSM is able to mitigate the impact of increased fuel costs through fuel surcharge revenues from customers. Foreign Exchange Sensitivity. KCSM uses the U.S. dollar as its functional currency; however, a portion of its revenues and expenses are denominated in Mexican pesos. Based on the volume of revenue and expense transactions denominated in Mexican pesos, revenue and expense fluctuations generally offset, with insignificant net impacts to operating income. The Company has exposure to fluctuations in the value of the Mexican peso against the U.S. dollar due to its net monetary assets that are denominated in Mexican pesos. The Company had Ps.146.7 million of net monetary assets at December 31, 2013 . The following table presents an estimate of the impact to the consolidated statements of comprehensive income that would result from a hypothetical one Mexican peso change in the exchange rate at December 31, 2013 . Sensitivity Analysis Hypothetical Affected Line Item change in in the Consolidated exchange Amount of Statement of rate Gain (Loss) Comprehensive Income Net monetary assets denominated in Mexican pesos at December 31, 2013: From Ps.13.1 ( $0.8 Foreign exchange Ps.146.7 million to Ps.14.1 million) gain (loss) From Ps.13.1 $0.9 Foreign exchange Ps.146.7 million to Ps.12.1 million gain (loss) Income taxes are paid in Mexican pesos, and as a result, the effective income tax rate reflects fluctuations in the value of the Mexican peso against the U.S. dollar. Most significantly, any gain or loss from the revaluation of net U.S. dollar-denominated monetary liabilities (primarily debt) into Mexican pesos is included in Mexican taxable income under Mexican tax law. As a result, a strengthening of the Mexican peso against the U.S. dollar for the reporting period will generally increase the Mexican cash tax obligation and the effective income tax rate, and a weakening of the Mexican peso against the U.S. dollar for the reporting period will generally decrease the Mexican cash tax obligation and the effective tax rate. The following table presents an estimate of the impact to the effective income tax rate and income tax expense that would result from a hypothetical one Mexican peso change in the exchange rate at December 31,2013 : Sensitivity Analysis Increase (Decrease) Affected Line Item in Effective Amount of in the Consolidated Income Tax Expense Statement of rate (Benefit) Comprehensive Income Hypothetical Change in Exchange Rate ( $28.0 From Ps.13.1 to Ps.14.1 (8.4%) million) Income tax expense $32.3 From Ps.13.1 to Ps.12.1 14.8% million Income tax expense During January 2014 , the Company entered into foreign currency forward contracts with an aggregate notional amount of $345.0 million to hedge its exposure to fluctuations in cash tax obligation due to changes in the value of the Mexican peso against the U.S. dollar. These contracts mature on December 31, 2014 , and obligate the Company to purchase a total of Ps.4,642.5 million at a weighted average exchange rate of Ps.13.46 to each U.S. dollar. The Company has not designated these foreign currency forward contracts as hedging instruments for accounting purposes. The foreign currency forward contracts will be measured at fair value each period and any change in fair value will be recognized in foreign exchange gain (loss) within the consolidated statements of comprehensive income. 27 -------------------------------------------------------------------------------- Table of Contents


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Source: Edgar Glimpses


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