The following discussion and analysis should be read in conjunction with the Consolidated Financial Statements and Notes.
OVERVIEW
We are one of the nation's premier transportation companies. OurNorfolk Southern Railway Company subsidiary operates approximately 19,500 route miles in 22 states and theDistrict of Columbia , serves every major container port in the easternUnited States , and provides efficient connections to other rail carriers.Norfolk Southern is a major transporter of industrial products, including chemicals, agriculture, and metals and construction materials. In addition, we operate the most extensive intermodal network in the East and are a principal carrier of coal, automobiles, and automotive parts. The execution of the initiatives in our strategic plan allowed us to achieve records for income from railway operations and railway operating ratio (a measure of the amount of operating revenues consumed by operating expenses) for the year. We continued our focus on improving the efficiency of our operations and utilization of our assets, allowing us to reduce our operating expenses by 3% in the face of a 1% revenue decline.
SUMMARIZED RESULTS OF OPERATIONS
2019 2018 2019 2018 2017 vs. 2018 vs. 2017 ($ in millions, except per share amounts) (% change) Income from railway operations$ 3,989 $ 3,959 $ 3,522 1 % 12 % Net income$ 2,722 $ 2,666 $ 5,404 2 % (51 %) Diluted earnings per share$ 10.25 $ 9.51 $ 18.61 8 % (49 %) Railway operating ratio (percent) 64.7 65.4 66.6 (1 %) (2 %) Income from railway operations rose in 2019 as a 3% reduction in railway operating expenses more than offset the impact of a 1% decline in railway operating revenues. In addition to higher income from railway operations, net income and diluted earnings per share growth in 2019 also benefited from a lower effective tax rate. Our continuing share repurchase program contributed to diluted earnings per share growth that exceeded that of net income. OnDecember 22, 2017 , the Tax Cuts and Jobs Act ("tax reform") was signed into law. The following table adjusts our 2017 U.S. Generally Accepted Accounting Principles (GAAP) financial results to exclude the effects of tax reform, specifically, the effects of remeasurement of net deferred tax liabilities related to the reduction of the federal tax rate from 35% to 21% (the "2017 tax adjustments"). We use these non-GAAP financial measures internally and believe this information provides useful supplemental information to investors to facilitate making period-to-period comparisons by excluding the 2017 tax adjustments. While we believe that these non-GAAP financial measures are useful in evaluating our business, this information should be considered as supplemental in nature and is not meant to be considered in isolation or as a substitute for the related financial information prepared in accordance with GAAP. In addition, these non-GAAP financial measures may not be the same as similar measures presented by other companies. K18 --------------------------------------------------------------------------------
Reconciliation of Non-GAAP Financial Measures
2017 Adjusted 2017 Reported 2017 (GAAP) tax adjustments (non-GAAP) ($ in millions, except per share amounts) Income from railway operations $ 3,522 $ (151) $ 3,371 Net income $ 5,404 $ (3,482) $ 1,922 Diluted earnings per share $ 18.61 $ (12.00) $ 6.61 Railway operating ratio (percent) 66.6 1.5 68.1 In the table below and the paragraph following, references to 2017 results and related comparisons use the adjusted, non-GAAP results from the reconciliation in the table above. 2018 vs. Adjusted Adjusted 2017 2019 2017 2019 2018 (non-GAAP) vs. 2018 (non-GAAP) ($ in millions, except per share amounts) (% change) Income from railway operations$ 3,989 $ 3,959 $ 3,371 1 % 17 % Net income$ 2,722 $ 2,666 $ 1,922 2 % 39 % Diluted earnings per share$ 10.25 $ 9.51 $ 6.61 8 % 44 % Railway operating ratio (percent) 64.7 65.4 68.1 (1 %) (4 %) Income from railway operations increased in 2018 as compared to 2017, as a 9% increase in railway operating revenues more than offset a 4% increase in adjusted operating expenses. In addition to higher income from railway operations, net income and diluted earnings per share growth in 2018 also benefited from a lower effective tax rate, primarily due to the enactment of tax reform. Finally, our share repurchase program resulted in diluted earnings per share growth that exceeded that of net income. K19 --------------------------------------------------------------------------------
DETAILED RESULTS OF OPERATIONS
Railway Operating Revenues
The following tables present a three-year comparison of revenues, volumes (units), and average revenue per unit by major commodity group. At the beginning of 2019, we made changes in the categorization of certain commodity groups within Merchandise. Prior period railway operating revenues, units, and revenue per unit have been reclassified to conform to the current presentation (see Note 2). Revenues 2019 2018 2019 2018 2017 vs. 2018 vs. 2017 ($ in millions) (% change) Merchandise: Chemicals$ 1,874 $ 1,858 $ 1,710 1 % 9 % Agriculture products 1,567 1,514 1,416 4 % 7 % Metals and construction 1,522 1,539 1,481 (1 %) 4 % Automotive 994 991 955 - % 4 % Forest and consumer 846 842 795 - % 6 % Merchandise 6,803 6,744 6,357 1 % 6 % Intermodal 2,824 2,893 2,452 (2 %) 18 % Coal 1,669 1,821 1,742 (8 %) 5 % Total$ 11,296 $ 11,458 $ 10,551 (1 %) 9 % Units 2019 2018 2019 2018 2017 vs. 2018 vs. 2017 (in thousands) (% change) Merchandise: Chemicals 514.9 523.3 488.6 (2 %) 7 % Agriculture products 528.5 538.9 524.8 (2 %) 3 % Metals and construction 721.3 759.7 761.2 (5 %) - % Automotive 394.7 403.9 423.1 (2 %) (5 %) Forest and consumer 273.0 293.3 293.7 (7 %) - % Merchandise 2,432.4 2,519.1 2,491.4 (3 %) 1 % Intermodal 4,207.2 4,375.7 4,074.1 (4 %) 7 % Coal 914.0 1,033.5 1,046.0 (12 %) (1 %) Total 7,553.6 7,928.3 7,611.5 (5 %) 4 % Revenue per Unit 2019 2018 2019 2018 2017 vs. 2018 vs. 2017 ($ per unit) (% change) Merchandise: Chemicals$ 3,640 $ 3,551 $ 3,501 3 % 1 % Agriculture products 2,964 2,809 2,697 6 % 4 % Metals and construction 2,110 2,026 1,946 4 % 4 % Automotive 2,517 2,453 2,257 3 % 9 % Forest and consumer 3,101 2,870 2,706 8 % 6 % Merchandise 2,797 2,677 2,552 4 % 5 % Intermodal 671 661 602 2 % 10 % Coal 1,826 1,762 1,665 4 % 6 % Total 1,495 1,445 1,386 3 % 4 % K20
-------------------------------------------------------------------------------- Revenues decreased$162 million in 2019 but increased$907 million in 2018 compared to the prior years. As reflected in the table below, lower 2019 revenues were the result of decreased volumes, partially offset by higher average revenue per unit, driven by pricing gains. The rise in 2018 revenues was the result of higher average revenue per unit, driven by pricing gains and higher fuel surcharge revenue, partially offset by the mix-related impacts of increased intermodal volume and decreased coal volume. In addition, overall volume also increased. The table below reflects the components of the revenue change by major commodity group. 2019 vs. 2018 2018 vs. 2017 Increase (Decrease) Increase (Decrease) ($ in millions) Merchandise Intermodal Coal Merchandise Intermodal Coal Volume$ (232) $ (111) $ (210) $ 71 $ 182 $ (21) Fuel surcharge revenue (14) (30) (35) 119 159 20 Rate, mix and other 305 72 93 197 100 80 Total$ 59 $ (69) $ (152) $ 387 $ 441 $ 79
Approximately 90% of our revenue base is covered by contracts that include
negotiated fuel surcharges. These revenues totaled
For 2020, merchandise and intermodal revenues are expected to increase, while coal revenues are anticipated to decline, resulting in overall revenues that are expected to be flat. MERCHANDISE revenues increased in both 2019 and 2018 compared with the prior years. In 2019, revenues grew due to higher average revenue per unit, driven by pricing gains, which were partially offset by volume declines in all commodity groups. In 2018, revenues grew due to higher average revenue per unit, driven by pricing gains and higher fuel surcharge revenue, as well as higher volumes. Volume gains in chemicals and agriculture products were partially offset by declines in automotive traffic. Chemicals revenues rose in both 2019 and 2018 compared with the prior years. In 2019, the rise was the result of higher average revenue per unit, due to pricing gains, which were partially offset by volume declines. Volume declines in natural gas, petroleum products, organic and inorganic chemicals, and plastics were partially offset by gains in crude oil and municipal waste. In 2018, the rise was the result of higher volume and higher average revenue per unit, due to pricing gains and higher fuel surcharge revenue. Volumes grew due to increased shipments of crude oil, liquefied petroleum gas, plastics, and municipal waste shipments, partially offset by a decrease in coal ash shipments. Agriculture products revenues rose in both 2019 and 2018 compared to the prior years. Growth in 2019 was due to higher average revenue per unit, a result of pricing gains, which more than offset volume declines. Volumes were down due to decreased shipments of ethanol, soybeans, and fertilizer, partially offset by increases in corn shipments. Growth in 2018 was due to higher average revenue per unit, a result of pricing gains and higher fuel surcharge revenues, and higher volume. Higher ethanol and fertilizer shipments more than offset declines in soybean and corn shipments. Metals and construction revenues declined in 2019 but increased in 2018 compared to the prior years. In 2019, volume declines were largely offset by higher average revenue per unit, the result of pricing gains. Volume declines in iron and steel, coil, sand, and scrap metal were partially offset by increases in aggregates shipments due to improved service and market strength. In 2018, higher average revenue per unit, the result of pricing gains and K21 -------------------------------------------------------------------------------- higher fuel surcharge revenue, drove the increase while volumes remained flat. Volume increases in frac sand shipments for use in natural gas drilling in the Marcellus and Utica regions were offset by declines in aggregates, cement, aluminum, and iron and steel. Automotive revenues were flat in 2019 and increased in 2018 compared to the prior years. In 2019, higher average revenue per unit, driven by price increases, offset volume declines that were primarily the result of decreases inU.S. light vehicle production and theUnited Automobile Workers strike in the fourth quarter. In 2018, higher average revenue per unit, driven by price increases and higher fuel surcharge revenues, more than offset volume declines. Traffic declines were the result of shortages of availability of multilevel equipment and scheduled automotive plant downtime. Forest and consumer revenues were flat in 2019 and increased in 2018 compared to the prior years. In 2019, higher average revenue per unit, the result of pricing gains, offset volume declines. Volume declines were primarily driven by reduced shipments of pulpboard, lumber and wood, and kaolin. In 2018, higher average revenue per unit, the result of pricing gains and higher fuel surcharge revenue drove the increase while volumes remained flat. Gains in pulpboard, a result of tightened truck capacity, were offset by decreases in pulp, woodchip, and graphic paper. INTERMODAL revenues decreased in 2019, but increased considerably in 2018 compared to the prior years. The decline in 2019 was driven by lower volumes, which were partially offset by higher average revenue per unit, a result of pricing gains. The rise in 2018 was driven by higher average revenue per unit, a result of increased fuel surcharge revenue and pricing gains, and higher volume.
Intermodal units by market were as follows:
2019 2018 2019 2018 2017 vs. 2018 vs. 2017 (units in thousands) (% change) Domestic 2,593.5 2,801.1 2,585.0 (7 %) 8 % International 1,613.7 1,574.6 1,489.1 2 % 6 % Total 4,207.2 4,375.7 4,074.1 (4 %) 7 %
Domestic volume fell in 2019 but increased in 2018. Volume was challenged in 2019 by stronger over-the-road competition. The rise in 2018 benefited from continued highway conversions due to tighter capacity in the truck market, higher truckload pricing, and growth from existing accounts.
International volume increased in both periods reflecting increased demand from new and existing customers, despite 2019 volume being somewhat tempered by tariff concerns.
COAL revenues decreased in 2019, but increased in 2018 compared with the prior years. The decrease in 2019 was a result of lower volume, which was partially offset by higher average revenue per unit, driven by pricing gains. Revenue growth in 2018 was the result of higher average revenue per unit, largely the result of pricing gains, which more than offset volume declines. K22 --------------------------------------------------------------------------------
As shown in the following table, total tonnage decreased in both periods.
2019 2018 2019 2018 2017 vs. 2018 vs. 2017 (tons in thousands) (% change) Utility 60,278 65,688 67,899 (8 %) (3 %) Export 23,324 28,046 26,460 (17 %) 6 % Domestic metallurgical 13,562 15,500 15,675 (13 %) (1 %) Industrial 4,655 5,410 5,545 (14 %) (2 %) Total 101,819 114,644 115,579 (11 %) (1 %) Utility coal tonnage declined in both periods from continued headwinds from low natural gas prices as well as additional natural gas and renewable energy generating capacity, that were slightly offset by our service improvements and customer inventory rebuilding. Export coal tonnage decreased in 2019 but increased in 2018. The decline in 2019 was a result of weak thermal seaborne pricing and coal supply disruptions at certain mines. The increase in 2018 was due to strong seaborne pricing that resulted in higher demand forU.S. coal. Domestic metallurgical coal tonnage was down in both years. The decline in 2019 was a reflection of challenging overall market conditions including softening domestic steel demand, customer sourcing changes, and plant outages. The decline in 2018 was a reflection of customer sourcing changes.
Industrial coal tonnage decreased in both years driven by customer sourcing changes and pressure from natural gas conversions.
Railway Operating Expenses
Railway operating expenses summarized by major classifications were as follows: 2019 2018 2019 2018 2017 vs. 2018 vs. 2017 ($ in millions) (% change) Compensation and benefits$ 2,751 $ 2,925 $ 2,979 (6 %) (2 %) Purchased services and rents 1,725 1,730 1,414 - % 22 % Fuel 953 1,087 840 (12 %) 29 % Depreciation 1,138 1,102 1,055 3 % 4 % Materials and other 740 655 741 13 % (12 %) Total$ 7,307 $ 7,499 $ 7,029 (3 %) 7 % In 2019, expenses fell as our strategic initiatives to improve productivity resulted in lower compensation, equipment rents, and materials expense. These decreases along with lower fuel prices and consumption were partially offset by lower gains on property sales, increased depreciation, and a write-off of a$32 million receivable as a result of a legal dispute. In 2018, expenses rose due to higher fuel prices as well as volume-related increases and costs associated with overall lower network velocity, partially offset by higher gains on property sales. K23 --------------------------------------------------------------------------------
Compensation and benefits decreased in 2019, reflecting changes in:
•employment levels (down$117 million ), •incentive and stock-based compensation (down$83 million ), •overtime and recrews (down$45 million ), •higher capitalized labor ($9 million ), •2018 employment tax refund ($31 million unfavorable in 2019), •pay rates (up$76 million ), and •other (down$27 million ). In 2018, compensation and benefits decreased, a result of changes in: •employment levels (down$61 million ), •health and welfare benefit rates for agreement employees (down$34 million ), •employment tax refund ($31 million benefit), •incentive and stock-based compensation (down$7 million ), •pay rates (up$34 million ), •overtime and recrews (up$58 million ), and •other (down$13 million ).
Our employment averaged 24,587 in 2019, compared with 26,662 in 2018, and 27,110 in 2017.
Purchased services and rents includes the costs of services purchased from outside contractors, including the net costs of operating joint (or leased) facilities with other railroads and the net cost of equipment rentals. In 2017, this line item includes a$151 million benefit from the 2017 tax adjustments ($36 million in purchased services and$115 million in equipment rents) in the form of higher income of certain equity investees. 2019 2018 2019 2018 2017 vs. 2018 vs. 2017 ($ in millions) (% change) Purchased services$ 1,434 $ 1,367 $ 1,233 5 % 11 % Equipment rents 291 363 181 (20 %) 101 % Total$ 1,725 $ 1,730 $ 1,414 - % 22 % The increase in purchased services in 2019 was the result of increased technology-related expenses, expenses associated with our headquarters relocation, and increased intermodal-related costs partially offset by decreased transportation activities. The increase in purchased services in 2018 was largely the result of the absence of the benefit from the 2017 tax adjustments, higher intermodal volume-related costs, additional transportation and engineering activities as well as higher technology costs. Equipment rents, which includes our cost of using equipment (mostly freight cars) owned by other railroads or private owners less the rent paid to us for the use of our equipment, decreased in 2019, but increased in 2018. In 2019, the decrease was largely due to improved network velocity and the absence of short-term locomotive resource costs incurred in the prior year. In 2018, the rise was due to the absence of the benefits from the 2017 tax adjustments, the impact of slower network velocity, the cost of additional short-term locomotive resources as well as growth in volume. Fuel expense, which includes the cost of locomotive fuel as well as other fuel used in railway operations, decreased in 2019, but increased in 2018. The change in both years was principally due to locomotive fuel prices (down 8% in 2019 and up 25% in 2018) which decreased expenses$82 million in 2019 but increased expenses$208 million in 2018. Locomotive fuel consumption decreased 4% in 2019, but increased 3% in 2018. We consumed K24 --------------------------------------------------------------------------------
approximately 451 million gallons of diesel fuel in 2019, compared with 472 million gallons in 2018 and 458 million gallons in 2017.
Depreciation expense increased in both periods, a reflection of growth in our roadway and equipment capital base as we continue to invest in our infrastructure and rolling stock, and technology.
Materials and other expenses increased in 2019 but decreased in 2018 as shown in the following table. 2019 2018 2019 2018 2017 vs. 2018 vs. 2017 ($ in millions) (% change) Materials$ 327 $ 362 $ 348 (10 %) 4 % Casualties and other claims 193 176 145 10 % 21 % Other 220 117 248 88 % (53 %) Total$ 740 $ 655 $ 741 13 % (12 %) Materials expense decreased in 2019, due primarily to lower locomotive repair costs as a result of fewer locomotives in service. In 2018, the increase was primarily a result of higher locomotive repair costs. Casualties and other claims expenses include the estimates of costs related to personal injury, property damage, and environmental matters. The 2019 expense increased, primarily the result of higher costs related to environmental remediation matters and higher personal injury costs. The 2018 expense increased, primarily the result of higher derailment-related costs. Other expense increased in 2019 but decreased in 2018, largely a result of gains from sales of operating properties. Gains from operating property sales amounted to$64 million ,$158 million , and$79 million in 2019, 2018, and 2017, respectively. In 2019, the increase was additionally impacted by the write-off of a$32 million receivable as a result of a legal dispute. In 2018, the decline was also impacted by the inclusion of net rental income from operating property previously included in "Other income - net" of$78 million , partially offset by increased costs as a result of the relocation of our train dispatchers toAtlanta, Georgia .
Other income - net
Other income - net increased in 2019 but decreased in 2018. The increase in 2019 was driven by higher returns on corporate-owned life insurance (COLI) investments and increased gains on sales of non-operating property, which more than offset a$49 million impairment loss related to our natural resource assets that we are actively marketing to sell. The decline in 2018 was driven by the absence of net rental income as discussed above and unfavorable returns from COLI investments. Income Taxes The effective income tax rate was 22.0% in 2019, compared with 23.1% in 2018 and negative 72.8% in 2017. Both 2019 and 2018 benefited from favorable reductions in deferred taxes for state tax law changes and certain business tax credits, while 2019 and 2017 benefited from higher returns from COLI. Income taxes in 2018 benefited from the effects of the enactment of tax reform in late 2017 that lowered the federal corporate income tax rate. Income taxes in 2017 included a benefit of$3,331 million related to the effects of the enactment of tax reform from the reduction in our net deferred tax liabilities driven by the change in the federal rate. All three years benefited from favorable tax benefits associated with stock-based compensation. K25 --------------------------------------------------------------------------------
For 2020, we expect the effective income tax rate to range from 23% to 24%.
FINANCIAL CONDITION, LIQUIDITY, AND CAPITAL RESOURCES
Cash provided by operating activities, our principal source of liquidity, was$3.9 billion in 2019,$3.7 billion in 2018, and$3.3 billion in 2017. The increases in both 2019 and 2018 were primarily the result of improved operating results. We had working capital deficits of$219 million and$729 million atDecember 31, 2019 , and 2018, respectively. Cash, cash equivalents, and restricted cash totaled$580 million and$446 million atDecember 31, 2019 , and 2018, respectively. We expect cash on hand combined with cash provided by operating activities will be sufficient to meet our ongoing obligations. Contractual obligations atDecember 31, 2019 , include interest on fixed-rate long-term debt, long-term debt (Note 9), unconditional purchase obligations (Note 17), operating leases (Note 10), long-term advances from Conrail and agreements withConsolidated Rail Corporation (CRC) (Note 6), and unrecognized tax benefits (Note 4): 2021 - 2023 - 2025 and Total 2020 2022 2024 Subsequent Other ($ in millions)
Interest on fixed-rate long-term debt
13,005 316 1,189 1,000 10,500 - Unconditional purchase obligations 1,225 499 521 82 123 - Operating leases 630 110 183 131 206 - Long-term advances from Conrail 280 - - - 280 - Agreements with CRC 176 40 80 56 - - Unrecognized tax benefits* 24 - - - - 24 Total$ 30,625 $ 1,533 $ 3,043 $ 2,257 $ 23,768 $ 24
* This amount is shown in the Other column because the year of settlement cannot be reasonably estimated.
Off balance sheet arrangements consist primarily of unrecognized obligations, including unconditional purchase obligations and future interest payments on fixed-rate long-term debt, which are included in the table above. In addition, we entered into a synthetic lease during 2019 which is discussed further in Note 10. Cash used in investing activities was$1.8 billion in 2019, compared with$1.7 billion in 2018, and$1.5 billion in 2017. In 2019, increased corporate owned life insurance activity and higher property additions were partially offset by increased proceeds from property sales. In 2018, higher property additions drove the increase.
Capital spending and track and equipment statistics can be found within the "Railway Property" section of Part I of this report on Form 10-K. For 2020, we expect capital spending to approximate 16% to 18% of revenues.
Cash used in financing activities was$2.0 billion in 2019, compared with$2.3 billion in 2018, and$2.0 billion in 2017. Both year-over-year comparisons reflect higher debt repayments and increased dividends. In 2019, the decrease was also impacted by fewer repurchases of common stock. In 2018, the increase was also impacted by increased repurchases of common stock, but tempered by increased proceeds from borrowings. Share repurchases totaled$2.1 billion in 2019,$2.8 billion in 2018, and$1.0 billion in 2017 for the purchase and retirement of 11.3 million, 17.1 million (including 7.0 million shares repurchased for$1.2 billion under the Accelerated Share Repurchase (ASR) program), and 8.2 million shares, respectively. As ofDecember 31, 2019 , 28.0 million shares remain authorized by our Board of Directors for repurchase. The timing and volume of future K26 --------------------------------------------------------------------------------
share repurchases will be guided by our assessment of market conditions and other pertinent factors. Any near-term purchases under the program are expected to be made with internally generated cash, cash on hand, or proceeds from borrowings.
InMay 2019 , we issued$200 million of 3.80% senior notes due 2028,$400 million of 4.10% senior notes due 2049, and$200 million of 5.10% senior notes due 2118. InNovember 2019 , we issued$400 million of 2.55% senior notes due 2029, and$400 million of 3.40% senior notes due 2049. InMay 2019 , we also renewed and amended our accounts receivable securitization program, increasing our maximum borrowing capacity from$400 million to$450 million with a term expiring inMay 2020 . We had no amounts outstanding at bothDecember 31, 2019 and 2018. We discuss our credit agreement and our accounts receivable securitization program in Note 9, and we have authority from our Board of Directors to issue an additional$1.6 billion of debt or equity securities through public or private sale, all of which provide for access to additional liquidity should the need arise. Our debt-to-total capitalization ratio was 44.5% atDecember 31, 2019 , compared with 42.0% atDecember 31, 2018 . Upcoming annual debt maturities are disclosed in Note 9. Overall, our goal is to maintain a capital structure with appropriate leverage to support our business strategy and provide flexibility through business cycles.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires us 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 revenue and expenses during the reporting period. These estimates and assumptions may require judgment about matters that are inherently uncertain, and future events are likely to occur that may require us to make changes to these estimates and assumptions. Accordingly, we regularly review these estimates and assumptions based on historical experience, changes in the business environment, and other factors we believe to be reasonable under the circumstances. The following critical accounting policies are a subset of our significant accounting policies described in Note 1.
Pensions and Other Postretirement Benefits
Accounting for pensions and other postretirement benefit plans requires us to make several estimates and assumptions (Note 12). These include the expected rate of return from investment of the plans' assets and the expected retirement age of employees as well as their projected earnings and mortality. In addition, the amounts recorded are affected by changes in the interest rate environment because the associated liabilities are discounted to their present value. We make these estimates based on our historical experience and other information that we deem pertinent under the circumstances (for example, expectations of future stock market performance). We utilize an independent actuarial consulting firm's studies to assist us in selecting appropriate actuarial assumptions and valuing related liabilities. In recording our net pension benefit, we assumed a long-term investment rate of return of 8.25%, which was supported by the long-term total rate of return on plan assets since inception, as well as our expectation of future returns. A one-percentage point change to this rate of return assumption would result in a$23 million change in pension expense. We review assumptions related to our defined benefit plans annually, and while changes are likely to occur in assumptions concerning retirement age, projected earnings, and mortality, they are not expected to have a material effect on our net pension expense or net pension liability in the future. The net pension liability is recorded at net present value using discount rates that are based on the current interest rate environment in light of the timing of expected benefit payments. We utilize analyses in which the projected annual cash flows from the pension and postretirement benefit plans are matched with yield curves based on an appropriate universe of high-quality corporate bonds. We use the results of the yield curve analyses to select the discount rates that match the payment streams of the benefits in these plans. A one-percentage point change to this discount rate assumption would result in about an$18 million change in pension expense. K27 --------------------------------------------------------------------------------
Properties and Depreciation
Most of our assets are long-lived railway properties (Note 7). "Properties" are stated principally at cost and are depreciated using the group method whereby assets with similar characteristics, use, and expected lives are grouped together in asset classes and depreciated using a composite depreciation rate. See Note 1 for a more detailed discussion of the assumptions and estimates in this area. Expenditures, including those on leased assets, that extend an asset's useful life or increase its utility are capitalized. Expenditures capitalized include those that are directly related to a capital project and may include materials, labor, and other direct costs, in addition to an allocable portion of indirect costs that relate to a capital project. A significant portion of our annual capital spending relates to the replacement of self-contructed assets. Costs related to repairs and maintenance activities that, in our judgment, do not extend an asset's useful life or increase its utility are expensed when such repairs are performed. Depreciation expense for 2019 totaled$1.1 billion . Our composite depreciation rates for 2019 are disclosed in Note 7; a one year increase (or decrease) in the estimated average useful lives of depreciable assets would have resulted in an approximate$40 million decrease (or increase) to depreciation expense.
Personal Injury
Casualties and other claims expense, included in "Materials and other" in the Consolidated Statements of Income, includes our accrual for personal injury liabilities.
To aid in valuing our personal injury liability and determining the amount to accrue with respect to such claims during the year, we utilize studies prepared by an independent consulting actuarial firm. The actuarial firm studies our historical patterns of reserving for claims and subsequent settlements, taking into account relevant outside influences. We adjust the liability quarterly based upon our assessment and the results of the study. Our estimate is subject to inherent limitation given the difficulty of predicting future events and as such the ultimate loss sustained may vary from the estimated liability recorded.
For a more detailed discussion of the assumptions and estimates in accounting for personal injury see Note 17.
Income Taxes
Our net deferred tax liability totaled$6.8 billion atDecember 31, 2019 (Note 4). This liability is estimated based on the expected future tax consequences of items recognized in the financial statements. After application of the federal statutory tax rate to book income, judgment is required with respect to the timing and deductibility of expenses in our income tax returns. For state income and other taxes, judgment is also required with respect to the apportionment among the various jurisdictions. A valuation allowance is recorded if we expect that it is more likely than not that deferred tax assets will not be realized. We have a$54 million valuation allowance on$513 million of deferred tax assets as ofDecember 31, 2019 , reflecting the expectation that almost all of these assets will be realized. OTHER MATTERS Labor Agreements Approximately 80% of our railroad employees are covered by collective bargaining agreements with various labor unions. Pursuant to the Railway Labor Act, these agreements remain in effect until new agreements are reached, or until the bargaining procedures mandated by the Railway Labor Act are completed. We largely bargain nationally in concert with other major railroads, represented by the National Carriers Conference Committee. Moratorium provisions in the labor agreements govern when the railroads and unions may propose changes to the agreements. K28 --------------------------------------------------------------------------------
The next round of bargaining commenced on
Market Risks
AtDecember 31, 2019 , we had no outstanding debt subject to interest rate fluctuations. Market risk for fixed-rate debt is estimated as the potential increase in fair value resulting from a one percentage point decrease in interest rates as ofDecember 31, 2019 , and amounts to an increase of approximately$2.1 billion to the fair value of our debt atDecember 31, 2019 . We consider it unlikely that interest rate fluctuations applicable to these instruments will result in a material adverse effect on our financial position, results of operations, or liquidity.
New Accounting Pronouncements
For a detailed discussion of new accounting pronouncements, see Note 1.
Inflation
In preparing financial statements, GAAP requires the use of historical cost that disregards the effects of inflation on the replacement cost of property. As a capital-intensive company, we have most of our capital invested in long-lived assets. The replacement cost of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical cost.
FORWARD-LOOKING STATEMENTS
Certain statements in Management's Discussion and Analysis of Financial Condition and Results of Operations are "forward-looking statements" within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, as amended. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties, and other factors that may cause our actual results, levels of activity, performance, or our achievements or those of our industry to be materially different from those expressed or implied by any forward-looking statements. In some cases, forward-looking statements can be identified by terminology such as "may," "will," "could," "would," "should," "expect," "plan," "anticipate," "intend," "believe," "estimate," "project," "consider," "predict," "potential," "feel," or other comparable terminology. We have based these forward-looking statements on our current expectations, assumptions, estimates, beliefs, and projections. While we believe these expectations, assumptions, estimates, beliefs, and projections are reasonable, such forward-looking statements are only predictions and involve known and unknown risks and uncertainties, many of which involve factors or circumstances that are beyond our control. These and other important factors, including those discussed in Item 1A "Risk Factors," may cause actual results, performance, or achievements to differ materially from those expressed or implied by these forward-looking statements. The forward-looking statements herein are made only as of the date they were first issued, and unless otherwise required by applicable securities laws, we disclaim any intention or obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information required by this item is included in Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the heading "Market Risks."
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