FORM 10-Q

þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended March 31, 2005

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934

for the transition period from                      to

Commission File Number 1-4717

KANSAS CITY SOUTHERN

(816) 983-1303
(Company’s telephone number, including area code)

No Changes
(Former name, former address and former fiscal year, if changed since last report.)

Indicate by check mark whether the Company (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Company was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes þ    No o

Indicate by check mark whether the Company is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes þ    No o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

KANSAS CITY SOUTHERN
FORM 10-Q
MARCH 31, 2005

INDEX

KANSAS CITY SOUTHERN
FORM 10-Q
MARCH 31, 2005

PART I – FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

Introductory Comments

The Consolidated Financial Statements included herein have been prepared by Kansas City Southern (the “Company” or “KCS”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) have been condensed or omitted pursuant to such rules and regulations. The Company believes that the disclosures are adequate to enable a reasonable understanding of the information presented. These Consolidated Financial Statements should be read in conjunction with the consolidated financial statements and the notes thereto, as well as Management’s Discussion and Analysis of Financial Condition and Results of Operations, included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004 and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in this Form 10-Q. Results for the three months ended March 31, 2005 are not necessarily indicative of the results expected for the full year 2005.

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KANSAS CITY SOUTHERN

See accompanying notes to consolidated financial statements.

3

KANSAS CITY SOUTHERN

See accompanying notes to consolidated financial statements.

4

KANSAS CITY SOUTHERN

See accompanying notes to consolidated financial statements.

5

KANSAS CITY SOUTHERN

See accompanying notes to consolidated financial statements.

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KANSAS CITY SOUTHERN

1.

Accounting Policies and Interim Financial Statements. In the opinion of the management of KCS, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring adjustments) necessary to present fairly the financial position of the Company and its subsidiary companies as of March 31, 2005 and December 31, 2004, the results of its operations for the three months ended March 31, 2005 and 2004, its cash flows for the three months ended March 31, 2005 and 2004, and its changes in stockholders’ equity for the three months ended March 31, 2005. The accompanying consolidated financial statements have been prepared consistently with accounting policies described in Note 2 to the consolidated financial statements included in the Company’s Annual Report on Form 10-K as of and for the year ended December 31, 2004. The results of operations for the three month period ended March 31, 2005 are not necessarily indicative of the results to be expected for the full year 2005. For information regarding the Company’s critical accounting policies and estimates, please see Item 7 of the Company’s Annual Report on Form 10-K “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates.” Certain prior year amounts have been reclassified to conform to the current year presentation.

2.

Earnings Per Share Data. Basic earnings per common share is computed by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. Restricted shares granted to employees and officers (as described in Note 6) are included in weighted average shares for purposes of computing basic earnings per common share as they are earned. Diluted earnings per share reflects the potential dilution that could occur if convertible securities were converted into common stock or stock options were exercised. The following is a reconciliation from the weighted average shares used for the basic earnings per share computation to the shares used for the diluted earnings per share computation for the three months ended March 31, 2005 and 2004, respectively (in thousands):

For the periods presented, 13,389,120 shares related to the convertible preferred stock were excluded from the computation of diluted earnings per share because the inclusion of these shares was antidilutive to earnings per share. For the three months ended March 31, 2005 and 2004, 5,000 and 615,000 shares, respectively, related to stock options were excluded from the calculation of diluted earnings per share because the exercise prices were greater than the average market price of common shares.

3.	Investments. Investments in unconsolidated affiliates and certain other investments accounted for under the equity method generally include all entities in which the Company or its subsidiaries have significant influence, but not more than 50% voting control. Investments in unconsolidated affiliates at March 31, 2005 include, among others, equity interests in Grupo Transportacion Ferroviaria Mexicana, S.A. de C.V. (“Grupo TFM”), Southern Capital Corporation, LLC (“Southern Capital”), and the Panama Canal Railway Company (“PCRC”).
	Grupo TFM. In July 1996, the Company and Transportación Maritima Mexicana, S.A. de C.V. (now Grupo TMM, S.A., “TMM”) formed Grupo TFM to participate in the privatization of the Mexican railroad system. In December 1996, the Mexican government awarded Grupo TFM the right to acquire an 80% interest (representing 100% of the shares with unrestricted voting rights) in TFM for approximately 11.072 billion Mexican pesos (approximately $1.4 billion based on the U.S. dollar/Mexican peso exchange rate on the award date). TFM holds a 50-year concession (with the option of up to a 50-year extension subject to certain conditions) to operate the Mexican railroad system that directly links Mexico City and Monterrey (as well as Guadalajara through trackage rights) with the ports of Lazaro Cardenas, Veracruz and Tampico and the Mexican/United States border crossings of Nuevo Laredo-Laredo, Texas and Matamoros-Brownsville, Texas. TFM’s route network provides a connection to the major industrial and population areas of Mexico from the United States. TFM interchanges traffic with The Texas-Mexican Railway Company (“Tex-Mex”) and the Union Pacific Railroad Company (‘‘UP’’) at Laredo, Texas.

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The Company and TMM exercised their call option and, on July 29, 2002, completed the purchase of the Mexican government’s 24.6% ownership of Grupo TFM. The Mexican government’s ownership interest of Grupo TFM was purchased by TFM for $256.1 million, utilizing a combination of proceeds from an offering by TFM of debt securities, a credit from the Mexican government for the reversion of certain rail facilities and other resources. This transaction resulted in an increase in the Company’s ownership percentage of Grupo TFM from 36.9% to approximately 46.6%. The purchase price was calculated by accreting the Mexican government’s initial investment of approximately $199 million from the date of the Mexican government’s investment through the date of the purchase, using the interest rate on one-year U.S. Treasury securities.

At March 31, 2005, the Company’s investment in Grupo TFM was approximately $388.5 million. The Company’s interest in Grupo TFM was approximately 46.6%, with TMM owning approximately 48.5%, and the remaining 4.9% owned indirectly by the Mexican government through its 20% ownership of TFM. The Company had a management services agreement with Grupo TFM to provide certain consulting and management services. As of March 31, 2005 and December 31, 2004, $2.8 million and $2.5 million, respectively, was reflected as a related party account receivable in the Company’s consolidated balance sheet related to this management services agreement. Total management fees billed to Grupo TFM were $.3 million and $.3 million for the first quarter of 2005 and 2004, respectively. For the first quarter of 2005, the Company accounted for its investment in Grupo TFM under the equity method.

The Company was party to certain agreements with TMM covering Grupo TFM, which contained ‘‘change of control’’ provisions, provisions intended to preserve the Company’s and TMM’s proportionate ownership of the venture, and super majority provisions with respect to voting on certain significant transactions. Such agreements also provided a right of first refusal in the event that either party initiated a divestiture of its equity interest in Grupo TFM. Under certain circumstances, such agreements could have effected the Company’s ownership percentage and rights in these equity affiliates. All of these agreements terminated upon completion of the acquisition by the Company of the shares of Grupo TFM controlled by TMM as described below.

KCS and TMM Enter Into Acquisition Agreement. On December 15, 2004, the Company entered into the Amended and Restated Acquisition Agreement (the “Acquisition Agreement”) with TMM and other parties under which KCS would acquire control of TFM through the purchase of shares of common stock of Grupo TFM (“the Acquisition”). Grupo TFM holds an 80% economic interest in TFM and all of the shares of stock with full voting rights of TFM. The remaining 20% economic interest in TFM is owned by the Mexican government in the form of shares with limited voting rights. The Mexican government has put rights with respect to its TFM shares as discussed below.

Under the terms of the Acquisition Agreement, KCS acquired all of TMM’s interest in Grupo TFM on April 1, 2005 for $200.0 million in cash, 18 million shares of KCS common stock, $47.0 million in two-year promissory note (the “Escrow Note”), and up to $110.0 million payable (“VAT Contingency Payment”) in a combination of cash and KCS common stock. As of March 31, 2005, cash of $200.0 million was deposited in a restricted escrow account. Both the $200.0 million cash and the 18 million shares of KCS common stock were payable at closing. The $47 million Escrow Notes are subject to indemnification provisions of the Acquisition Agreement. The amount payable under the Escrow Note can be reduced by the amount of certain potential losses related to breaches of certain representations, warranties, or covenants in the Acquisition Agreement or claims relating thereto, or under other conditions specified in the Indemnity Escrow Agreement containing the terms under which the Escrow Notes are to be held, reduced and released. An additional $110.0 million could become payable upon the Final Resolution of the VAT Claim and Put, as defined in the Acquisition Agreement.

In connection with the Acquisition, KCS has entered into a consulting agreement with José F. Serrano International Business, S.A. de C.V. (“JSIB”), a consulting company controlled by Jose Serrano, Chairman of the Board of TMM and, prior to the closing of the Acquisition, of Grupo TFM and TFM, which agreement became effective upon the closing of the Acquisition. Under this agreement, JSIB will provide consulting services to KCS in connection with the portion of the business of KCS in Mexico for a period of three years. As consideration for these services, the consulting company receives an annual fee of $3.0 million. The Consulting Agreement requires KCS to deposit the total amount of annual fee payable under the Consulting Agreement ($9.0 million) in an escrow account to be held and released in accordance with the terms and conditions of the Consulting Agreement and the applicable escrow agreement.

On March 29, 2005 KCS shareholders approved the issuance of 18 million shares of common stock, plus the potential issuance of additional shares under certain circumstances, in conjunction with the proposed Acquisition. With this approval, all of the conditions precedent to the closing covered in the December 15, 2004 Acquisition Agreement were

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satisfied. KCS completed the purchase of the controlling interest in TFM from Grupo TMM on April 1, 2005. Beginning April 1, 2005, the financial results of Grupo TFM will be consolidated into KCS.

Mexican Government’s Put Rights With Respect to TFM Stock. Under the terms of the January 31, 1997 share purchase agreement through which Grupo TFM agreed to purchase the shares of TFM, as amended by the parties on June 9, 1997 (the “TFM Share Purchase Agreement”), the Mexican government has the right to compel the purchase of its 20% interest in TFM (referred to as the “Put”) by Grupo TFM following its compliance with the terms and conditions of the TFM Share Purchase Agreement. Upon exercise of the Put in accordance with the terms of the TFM Share Purchase Agreement, Grupo TFM would be obligated to purchase the TFM capital stock at the initial share price paid by Grupo TFM adjusted for interest and inflation. Prior to October 30, 2003, Grupo TFM filed suit in the Federal District Court of Mexico City seeking, among other things, a declaratory judgment interpreting whether Grupo TFM was obligated to honor its obligation under the TFM Share Purchase Agreement, as the Mexican government had not made any effort to sell the TFM shares subject to the Put prior to October 31, 2003. In its suit, Grupo TFM named TMM and KCS as additional interested parties. A Mexican Court has admitted Grupo TFM’s complaint. Grupo TFM also filed a suit seeking constitutional protection against the Mexican government exercising the Put, and that Court issued an injunction that blocked the Mexican government from exercising the Put. The Mexican government provided Grupo TFM with notice of its intention to sell its interest in TFM on October 30, 2003. Grupo TFM has responded to the Mexican government’s notice reaffirming its right and interest in purchasing the Mexican government’s remaining interest in TFM, but also advising the Mexican government that it would not take any action until its lawsuit seeking a declaratory judgment was resolved. KCS management does not believe it is likely that the Mexican government will seek to exercise the Put until the litigation is resolved. On completion of the Acquisition, KCS assumed TMM’s rights and obligations to make any payment upon the exercise by the Mexican government of the Put and indemnified TMM and its affiliates, and their respective officers, directors, employees and shareholders, against obligations or liabilities relating thereto. If KCS had been required to purchase this interest as of March 31, 2005, the total purchase price would have been approximately $468.0 million.

Commercial Suit. On December 3, 2004 the Mexican government filed a commercial lawsuit against TFM, Grupo TFM, TMM and KCS with a Mexican federal civil court. In the lawsuit, the Mexican government has requested a finding from the court as to whether the defendants had complied with all of their legal obligations arising out of the process of privatization of the Mexican National Railway (Ferrocarriles Nacionales de Mexico), in particular those related to the purchase by GTFM of the 20% limited voting stock that the Mexican government holds in TFM (the “PUT shares”). The court initially refused to accept all of the claims asserted by the Mexican government, but an Appellate Court found that all of the Mexican government’s allegations should have been admitted for trial, and ordered the trial court to admit and serve the Government’s original petition. The Appellate Court rejected the Mexican government’s request to provisionally attach the VAT certificate and any replacement certificate the Federal Treasury may issue in the future. The trial court has entered an order consistent with the instructions from the Appellate Court, and KCS is expecting service of the new complaint at anytime. TFM, Grupo TFM and Grupo TMM appealed the admission of this suit, and The Appellate Court ruled against the appeal. TFM, Grupo TFM and Grupo TMM are concurrently considering whether to further appeal that decision and the order admitting the Government’s original petition. The trial court ruled that the Mexican government could effect service of process on KCS by delivering the complaint to Grupo TMM’s offices. Grupo TMM has filed several legal actions seeking a determination that the service was invalid on the grounds that KCS does not have its address at the Grupo TMM offices, and that the Mexican government should notify KCS at its corporate address in the United States. KCS has not answered or appeared in the case, as it believes it has not been properly notified of the complaint. We believe that this suit is without merit and that TFM, GTFM, GTMM and KCS have fully satisfied their legal obligations relating to the privatization of TFM. However, there can be no assurance that we or the other defendants will prevail. In the event that Mexican government prevails and no further right of appeal is available to or exercised by the defendants, KCS could be obligated to purchase the Put shares at the price established in the 1997 TFM Purchase and Sale Agreement, and to pay the Mexican government damages for failing to comply with the Put obligation in accordance with the terms of that Agreement.

Value Added Tax (“VAT”) Lawsuit and VAT Contingency Payment under the Acquisition Agreement. The VAT lawsuit (“VAT Claim”) arose out of the Mexican Treasury’s delivery of a VAT credit certificate to a Mexican governmental agency rather than to TFM in 1997. The face value of the VAT credit at issue is 2,111,111,790 pesos or approximately $189 million in U.S. dollars, based on current exchange rates. The amount of the VAT refund will, in accordance with Mexican law, reflect the face value of the VAT credit adjusted for inflation and interest from 1997.

On January 19, 2004, TFM received a Special Certificate from the Mexican Federal Treasury in the amount of $2.1 billion pesos. The Special Certificate delivered to TFM on January 19, 2004 has the same face amount as the original VAT refund claimed by TFM in 1997. TFM also filed a complaint against the Mexican government, seeking to have the amount of the Special Certificate adjusted to reflect interest and inflation in accordance with Mexican law. The Mexican Fiscal Court initially denied TFM’s claim. In a decision dated November 24, 2004, the Mexican Federal Appellate Court upheld TFM’s claim that it is entitled to inflation and interest from 1997 on the VAT refund. The Federal Appellate Court remanded the case to the Mexican Fiscal Court with instructions to enter a new order consistent with this decision. On January 26, 2005, the Mexican Fiscal Court issued from the bench an oral order implementing the Appellate Court decision. On February 18, 2005, TFM was served with the confirming written order from the Mexican Fiscal Court.

Under the Acquisition Agreement, in the event of the Final Resolution of the VAT Claim and Put (as such term is defined in the Acquisition Agreement), KCS will be obligated to pay to TMM the VAT Contingency Payment of up to $110 million, payable in a combination of cash and KCS common stock.

1997 Tax Audit Summary. TFM was served on January 19, 2004 with an official letter notifying TFM of the Mexican government’s preliminary findings and conclusions arising from its tax audit of TFM’s 1997 tax returns (“Tax Audit Summary”). In the Tax Audit Summary, the Mexican government notified TFM of its preliminary conclusion that the documentation provided by TFM in support of the VAT refund claim and depreciation of the TFM concession title, and the assets reported on TFM’s 1997 tax return do not comply with the formalities required by the applicable tax legislation. In addition, the Mexican government attached the Special Certificate pending resolution of the audit. TFM has advised that it has, within the time allowed by the Tax Audit Summary, contested the conclusions of the Mexican tax authorities, and it has filed a constitutional appeal against the Tax Audit Summary, alleging the process followed by the Mexican government violated TFM’s constitutional rights. On March 16, 2005, TFM was notified by the Mexican Fiscal Administration Service (“Servicio de Administracion Tributaria” or the “SAT”) that it had finished its audit of TFM’s 1997 tax returns. The SAT has not yet assessed any penalties or taxes against TFM as a result of the audit. In the notice, the SAT stated that TFM did not supply documentation complying with the requirements of the Mexican fiscal code and, therefore, it was not entitled in its 1997 tax returns to depreciate and deduct the concession title, the railway equipment and other assets that were assets of

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TFM at the time that it was privatized in 1997. KCS continues discussions with the Mexican government to resolve the outstanding disputes between the parties.

Acquisition of Mexrail. On August 16, 2004, KCS, TMM and TFM entered into a new Stock Purchase Agreement (“New Mexrail Stock Purchase Agreement’’). Pursuant to the terms of that agreement, KCS purchased from TFM 51% of the outstanding shares of Mexrail, a wholly-owned subsidiary of TFM, for $32.7 million and placed those shares into trust pending approval of the Surface Transportation Board (“STB”) to exercise common control over KCSR, Gateway Eastern and Tex-Mex. On November 29, 2004, the STB approved the Company’s application for authority to control KCSR, Gateway Eastern and Tex-Mex. This approval became effective on December 29, 2004.

The aggregate purchase price was $57.4 million including $32.7 million of cash with the remaining amount consisting of net receivables and payables with Mexrail and Grupo TFM. The acquisition of Mexrail links KCSR to TFM. The shares representing 51% ownership of Mexrail were transferred by the trustee to KCS on January 1, 2005. KCS has recorded its option to purchase the remaining 49% of Mexrail for $31.4 million as a current liability. Accordingly, KCS has consolidated the results of Mexrail since January 1, 2005 and the financial results of Mexrail have been included within the consolidated KCS financial statements since January 1, 2005. The Company’s management has completed an evaluation of the fair value of the assets and liabilities of Mexrail in the first quarter of 2005. The following table summarizes the estimated fair values of the assets acquired and liabilities assumed at the date of acquisition.

The allocation of the purchase price above reflects preliminary estimates to various amounts which are subject to change as the Company obtains additional information relating to the fair values of assets and liabilities of Mexrail.

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The following table reflects the pro forma financial results for the three months ended March 31, 2004 as though the acquisition had occurred on January 1, 2004: (in millions, except for shares outstanding, which are in thousands and per share amounts which are in cents.)

PCRC redeems preferred shares held by International Finance Corporation. On March 28, 2005, PCRC and the International Finance Corporation (“IFC”) finalized an agreement whereby PCRC would redeem the shares subscribed and owned by IFC pursuant to the IFC Subscription. Under the agreement, PCRC paid to the IFC $10.5 million. The IFC preferred shares had a recorded value of $5.0 million and approximately $2.6 million in accrued unpaid dividends. When the transaction was completed, PCRC recorded an additional cost of approximately $2.9 million to reflect the premium paid to IFC. As a result, KCS recorded its share of this cost of approximately $1.5 million in recording its equity in earnings of PCRC in the first quarter of 2005.

Condensed financial information of certain unconsolidated affiliates is shown below. All amounts, including those for Grupo TFM, are presented under U.S. GAAP. Financial information of immaterial unconsolidated affiliates has been omitted:

Financial Condition (dollars in millions):

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Operating Results (dollars in millions):

4.	Noncash Investing and Financing Activities. The Company initiated the Sixteenth Offering of KCS common stock under the Employee Stock Purchase Plan (“ESPP”) during 2004. Stock subscribed under the Sixteenth Offering will be issued to employees in 2006 and is being paid for through employee payroll deductions in 2005. During the first three months of 2005, the Company has received approximately $0.5 million from payroll deductions associated with the Sixteenth Offering of the ESPP. In the first quarter of 2005, the Company issued approximately 206,000 shares of KCS common stock under the Fifteenth Offering of the ESPP. Shares of the Fifteenth Offering of the ESPP at a purchase price of approximately $2.5 million were subscribed and paid for through employee payroll deductions in 2004.
5.	Derivative Financial Instruments. The Company does not engage in the trading of derivatives for speculative purposes but uses them for risk management purposes only. The Company’s objective for using derivative instruments is to manage the risk of volatility in prices of diesel fuel. In general, the Company enters into derivative transactions in limited situations based on management’s assessment of current market conditions and perceived risks. Management intends to respond to evolving business and market conditions in order to manage risks and exposures associated with the Company’s various operations, and in doing so, may enter into such transactions more frequently as deemed appropriate.
	Fuel Derivative Transactions
	At March 31, 2005, the Company was a party to one fuel swap agreement for a notional amount of approximately 1.9 million gallons of fuel. Under the terms of the swap, the Company receives a variable price based upon an average of the spot prices calculated on a monthly basis as reported through a petroleum price reporting service and pays a fixed price determined at the time the Company enters into the swap transaction. The variable price the Company receives is approximately equal to the price the Company pays in the market for locomotive fuel. By entering into swap transactions, the Company is able to fix the cost of fuel for the notional amount of gallons hedged.
	A summary of the swap agreements to which KCSR was a party as of March 31, 2005 follows:

	Cash settlements of the swap occur on a monthly basis on the fifth business day of the month following the month in which the settlement is calculated. As of March 31, 2005, the fair market value of the benefit of the swap was $1.7 million. For the years ended December 31, 2004 and 2003, KCSR consumed 59.2 million and 55.4 million gallons of fuel, respectively. Fuel hedging transactions resulted in a decrease in fuel expense of $0.4 million and $0.2 million in the first quarter of 2005 and 2004, respectively.
6.	Stock Options and Other Stock Plans. Proceeds received from the exercise of stock options or subscriptions are credited to the appropriate capital accounts in the period they are exercised.
	Stock Options. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123 “Accounting for Stock-Based Compensation” (“SFAS 123”) in October 1995. SFAS 123 allows companies to continue under the approach set forth in Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” (“APB 25”), for recognizing stock-based compensation expense in their financial statements. KCS’s practice is to set the option price equal to the market price of the stock at date of grant, therefore, no compensation expense is recognized under APB 25. Under SFAS 123, companies must either record compensation expense based on the estimated grant date fair value of stock options granted or disclose the impact on net income as if they had adopted the fair value method (for grants

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subsequent to December 31, 1994). If KCS had measured compensation cost for the KCS stock options granted to its employees and shares subscribed by its employees under the ESPP, under the fair value based method prescribed by SFAS 123, net income and earnings per share would have been as follows:

Restricted Stock. The Kansas City Southern 1991 Amended and Restated Stock Option and Performance Award Plan provides for the granting of restricted stock awards to officers and other designated employees. These awards are subject to forfeiture if employment terminates during the vesting period which is generally five years. During the quarter ended March 31, 2005, 232,632 restricted shares were granted at a weighted-average fair value of $19.41. The value of restricted shares is amortized to expense over the vesting period. For the quarter ended March 31, 2005, the Company expensed $0.2 million related to restricted stock earned.

7.	Commitments and Contingencies. The Company has had no significant changes in its outstanding litigation or other commitments and contingencies from that previously reported in Note 9 of the Company’s Annual Report on Form 10-K for the year ended December 31, 2004, except as described in the following paragraph:
	The Company has established its personal injury and casualty reserves based on an assumption that it would have the benefit of insurance under existing policies for any liability above the applicable self-insured retention. With respect to certain claims that have substantial exposure to losses in excess of the Company’s self-insured retention limit, the Company’s insurance carriers have raised recently questions concerning their obligation to provide coverage. At this time, the carriers have not formally denied coverage concerning any claim. Even if formal denial of coverage should occur, the Company presently believes that it has strong basis to successfully oppose any such denial and that it is probable that this insurance coverage will be sustained. However, in the event the Company is unsuccessful in opposing such denials, if any, by the insurance carriers, the Company would likely incur additional costs in settling the related personal injury and casualty claims. While the Company is not presently able to reliably estimate such amounts, those additional costs could be material. The accompanying financial statements do not include any accruals related to such possible additional costs.
	On February 24, 2005, the Company took one 28.5-mile branch line out of service for further assessment of track condition. The Company has entered into a ten-year lease with a short line railroad. Under this agreement, that railroad will be responsible for the operation and maintenance of this line.
8.	Other Post Employment Benefits. The Company provides certain medical, life and other post employment benefits other than pensions to its retirees. The medical and life plans are available to employees not covered under collective bargaining arrangements, who have attained age 60 and rendered ten years of service. Individuals employed as of December 31, 1992 were excluded from a specific service requirement. The medical plan is contributory and provides benefits for retirees, their covered dependents and beneficiaries. The medical plan provides for an annual adjustment of retiree contributions, and also contains, depending on the plan coverage selected, certain deductibles, co-payments, coinsurance and coordination with Medicare. The life insurance plan is non-contributory and covers retirees only. The Company’s policy, in most cases, is to fund benefits payable under these plans as the obligations become due. However, certain plan assets (money market funds held by a life insurance company) exist with respect to life insurance benefits. A life insurance company holds these assets and the Company receives an investment return on these assets based on the six-month Treasury Bill rate plus 25 basis points. The Company’s health care costs, excluding former Gateway Western Railway Company (“Gateway Western”) employees and certain former MidSouth Railroad employees, are limited to the increase in the Consumer Price Index (“CPI”) with a maximum annual increase of 5%. Accordingly, health care costs in excess of the CPI limit will be borne by the plan participants, and therefore assumptions regarding health care cost trend rates are not applicable.
	Based upon current regulations, the KCS plans are actuarially equivalent to Medicare part D benefits; however, provisions within the plans contain retiree cost sharing features which make any potential benefit to KCS from the subsidy entitlement unlikely to be material.

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Net periodic post employment benefit cost included the following components (in millions):

Under collective bargaining agreements, KCSR participates in a multi-employer benefit plan, which provides certain post-retirement health care and life insurance benefits to eligible union employees and certain retirees. Premiums under this plan are expensed as incurred and were $1.9 million in the year ended December 31, 2004. Based on existing rates, premium amounts are not expected to change substantially during the remainder of 2005 compared to 2004.

9.	New Accounting Pronouncements.

SFAS 123R

In December 2004, the FASB issued Statement of Financial Accounting Standard No. 123 (Revised), “Share-Based Payments” (“SFAS 123R”), which was initially effective for the first fiscal period ending after June 15, 2005. Under SFAS 123R, the Company will be required to measure the cost of employee service received in exchange for awards of stock options based upon the fair value of the options as of their grant date. The cost of the employee service will be recognized as compensation cost ratably over the option vesting period. Currently, the Company recognizes compensation expense pursuant to APB 25, whereby compensation expense is recognized to the extent that an option price is less than the market price of the stock at the date of the grant (the “Intrinsic Value”). Because KCS’s practice is to set the option exercise price equal to the market price of the stock as of the date of the grant, no compensation expense is recognized for financial reporting purposes. SFAS 123R allows the use of either the Black-Scholes or a lattice option-pricing model to calculate the fair value of options. SFAS 123R allows either a Modified Prospective Application, which applies to new awards and modified awards after the effective date, and to any unvested awards as service is rendered on or after the effective date, or a Modified Retrospective Application, which would apply to all prior years for which SFAS 123 was effective. Currently, the Company is evaluating these adoption alternatives and expects to complete this evaluation during the fourth quarter of 2005. Using the Black-Scholes method, the expense related to share based compensation would have been $0.1 million and $0.5 million for the quarters ended March 31, 2005 and 2004, respectively. The impact on future operating results will be dependent on the type and extent of stock-based compensation to be granted as determined by the Company’s Compensation Committee and cannot be determined at this time. Effective April 21, 2005, SFAS 123R was amended to change the effective date to the first interim or annual reporting period of the registrant’s first fiscal year beginning after June 15, 2005. Accordingly, the Company anticipates implementing SFAS 123R during the first quarter of 2006.

10.

Condensed Consolidating Financial Information. KCSR has outstanding $200 million of 9 1/2% senior notes due 2008 and $200 million of 7 1/2% senior notes due 2009. Both of these note issues are unsecured obligations of KCSR, however, they are also jointly and severally and fully and unconditionally guaranteed on an unsecured senior basis by KCS and certain of the subsidiaries (all of which are wholly-owned) within the KCS consolidated group. For each of these note issues, KCS registered exchange notes with the SEC that have substantially identical terms and associated guarantees and all of the initial senior notes for each issue have been exchanged for $200 million of registered exchange notes for each respective note issue.

The accompanying condensed consolidating financial information has been prepared and presented pursuant to SEC Regulation S-X, Rule 3-10 ‘‘Financial statements of guarantors and issuers of guaranteed securities registered or being registered.’’ This information is not intended to present the financial position, results of operations and cash flows of the individual companies or groups of companies in accordance with U.S. GAAP.

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CONDENSED CONSOLIDATING STATEMENTS OF INCOME

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CONDENSED CONSOLIDATING BALANCE SHEETS

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CONDENSED CONSOLIDATING STATEMENTS OF CASH FLOWS