10-Q 1 cnf_10q2.txt PAGE 1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2001 OR ___TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from N/A to N/A COMMISSION FILE NUMBER 1-5046 CNF Inc. (Formerly CNF Transportation Inc.) Incorporated in the State of Delaware I.R.S. Employer Identification No. 94-1444798 3240 Hillview Avenue, Palo Alto, California 94304 Telephone Number (650) 494-2900 Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months and (2) has been subject to such filing requirements for the past 90 days. Yes xx No Number of shares of Common Stock, $.625 par value, outstanding as of July 31, 2001: 48,842,907 PAGE 2 CNF INC. FORM 10-Q Quarter Ended June 30, 2001 ___________________________________________________________________________ ___________________________________________________________________________ INDEX PART I. FINANCIAL INFORMATION Page Item 1. Financial Statements Consolidated Balance Sheets - June 30, 2001 and December 31, 2000 3 Statements of Consolidated Operations - Three and six months Ended June 30, 2001 and 2000 5 Statements of Consolidated Cash Flows - Six months Ended June 30, 2001 and 2000 6 Notes to Consolidated Financial Statements 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 18 PART II. OTHER INFORMATION Item 1. Legal Proceedings 26 Item 6. Exhibits and Reports on Form 8-K 27 SIGNATURES 27 PAGE 3 ITEM 1. FINANCIAL STATEMENTS CNF INC. CONSOLIDATED BALANCE SHEETS (Dollars in thousands) June 30, December 31, 2001 2000 ASSETS CURRENT ASSETS Cash and cash equivalents $ 131,470 $ 104,515 Trade accounts receivable, net 757,310 881,268 Other accounts receivable (Note 11) 86,351 59,478 Operating supplies, at lower of average cost or market 23,166 42,271 Prepaid expenses 55,039 47,301 Deferred income taxes 107,391 105,502 Net current assets of discontinued operations (Note 2) 2,904 - Total Current Assets 1,163,631 1,240,335 PROPERTY, PLANT AND EQUIPMENT, AT COST Land 148,451 130,101 Buildings and leasehold improvements 716,358 692,312 Revenue equipment 694,732 797,444 Other equipment 440,064 420,788 1,999,605 2,040,645 Accumulated depreciation and amortization (915,820) (934,123) 1,083,785 1,106,522 OTHER ASSETS Deferred charges and other assets (Note 10) 134,799 137,393 Capitalized software, net 85,291 89,829 Unamortized aircraft maintenance 52,301 242,468 Goodwill, net 249,864 254,887 Net non-current assets of discontinued operations (Note 2) 105,914 173,507 628,169 898,084 TOTAL ASSETS $2,875,585 $3,244,941 The accompanying notes are an integral part of these statements. PAGE 4 CNF INC. CONSOLIDATED BALANCE SHEETS (Dollars in thousands) June 30, December 31, 2001 2000 LIABILITIES AND SHAREHOLDERS' EQUITY CURRENT LIABILITIES Accounts payable $ 393,960 $ 418,157 Accrued liabilities (Note 11) 318,443 317,650 Accrued claims costs 139,906 145,558 Current maturities of long-term debt and capital leases 8,753 7,553 Income taxes payable - 1,777 Net current liabilities of discontinued operations (Note 2) - 68,214 Total Current Liabilities 861,062 958,909 LONG-TERM LIABILITIES Long-term debt and guarantees (Notes 4 and 10) 430,653 424,116 Long-term obligations under capital leases 110,473 110,533 Accrued claims costs 110,076 82,502 Employee benefits 267,409 252,482 Other liabilities and deferred credits 43,271 51,163 Aircraft lease return provision 76,998 33,851 Deferred income taxes 11,129 144,463 Total Liabilities 1,911,071 2,058,019 COMMITMENTS AND CONTINGENCIES (Note 11) COMPANY-OBLIGATED MANDATORILY REDEEMABLE PREFERRED SECURITIES OF SUBSIDIARY TRUST HOLDING SOLELY CONVERTIBLE DEBENTURES OF THE COMPANY (Note 9) 125,000 125,000 SHAREHOLDERS' EQUITY Preferred stock, no par value; authorized 5,000,000 shares: Series B, 8.5% cumulative, convertible, $.01 stated value; designated 1,100,000 shares; issued 815,632 and 824,902 shares, respectively 8 8 Additional paid-in capital, preferred stock 124,049 125,459 Deferred compensation, Thrift and Stock Plan (76,952) (80,602) Total Preferred Shareholders' Equity 47,105 44,865 Common stock, $.625 par value; authorized 100,000,000 shares; issued 55,559,257 and 55,426,605 shares, respectively 34,725 34,642 Additional paid-in capital, common stock 333,879 331,282 Retained earnings 631,189 855,314 Deferred compensation, restricted stock (1,561) (1,423) Cost of repurchased common stock (6,725,170 and 6,770,628 shares, respectively) (165,818) (166,939) 832,414 1,052,876 Accumulated Other Comprehensive Loss (Note 6) (40,005) (35,819) Total Common Shareholders' Equity 792,409 1,017,057 Total Shareholders' Equity 839,514 1,061,922 TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $2,875,585 $3,244,941 The accompanying notes are an integral part of these statements. PAGE 5 CNF INC. STATEMENTS OF CONSOLIDATED OPERATIONS (Dollars in thousands except per share amounts) Three Months Ended Six Months Ended June 30, June 30, 2001 2000 2001 2000 REVENUES $1,256,608 $1,401,146 $2,535,073 $2,723,040 Costs and Expenses Operating expenses (Note 5) 1,095,964 1,148,795 2,169,749 2,235,590 General and administrative 127,913 124,926 255,115 248,280 Depreciation 44,187 40,294 87,937 80,570 Restructuring and related charges (Note 5) 340,531 - 340,531 - 1,608,595 1,314,015 2,853,332 2,564,440 OPERATING INCOME (LOSS) (351,987) 87,131 (318,259) 158,600 Other Income (Expense) Investment income 641 593 1,370 864 Interest expense (7,234) (7,881) (15,027) (14,281) Dividend requirement on preferred securities of subsidiary trust (Note 9) (1,563) (1,563) (3,126) (3,126) Miscellaneous, net 482 1,309 1,309 3,988 (7,674) (7,542) (15,474) (12,555) Income (Loss) from Continuing Operations before Taxes (359,661) 79,589 (333,733) 146,045 Income Tax Benefit (Provision) 133,852 (33,825) 123,481 (62,069) INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE ACCOUNTING CHANGE (225,809) 45,764 (210,252) 83,976 Cumulative Effect of Accounting Change, net of tax (Note 1) - - - (2,744) Net Income (Loss) (225,809) 45,764 (210,252) 81,232 Preferred Stock Dividends 2,079 2,072 4,119 4,106 NET INCOME (LOSS) APPLICABLE TO COMMON SHAREHOLDERS $ (227,888) $ 43,692 $ (214,371) $ 77,126 Weighted-Average Common Shares Outstanding Basic shares 48,760,668 48,463,040 48,704,866 48,440,350 Diluted shares 48,760,668 56,361,884 48,704,866 56,377,108 Earnings (Loss) per Common Share (Note 8) Basic Net Income (Loss) before Accounting Change $ (4.67) $ 0.90 $ (4.40) $ 1.65 Accounting Change, net of tax - - - (0.06) Net Income (Loss) Applicable to Common Shareholders $ (4.67) $ 0.90 $ (4.40) $ 1.59 Diluted Net Income (Loss) before Accounting Change $ (4.67) $ 0.80 $ (4.40) $ 1.46 Accounting Change, net of tax - - - (0.05) Net Income (Loss) Applicable to Common Shareholders $ (4.67) $ 0.80 $ (4.40) $ 1.41 The accompanying notes are an integral part of these statements.
PAGE 6 CNF INC. STATEMENTS OF CONSOLIDATED CASH FLOWS (Dollars in thousands) Six Months Ended June 30, 2001 2000 CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD $ 104,515 $ 146,263 OPERATING ACTIVITIES Net income (loss) (210,252) 81,232 Adjustments to reconcile net income (loss) to net cash provided by operating activities: Cumulative effect of accounting change, net of tax - 2,744 Restructuring and related charges (Note 5) 340,531 - Depreciation and amortization 102,831 91,785 Decrease in deferred income taxes (135,469) (14,184) Amortization of deferred compensation 3,650 3,961 Provision for uncollectible accounts (Note 5) 38,013 7,964 Loss (gain) from sales of property 1,136 (641) Gain from sale of securities - (2,619) Changes in assets and liabilities: Receivables 76,648 (80,122) Prepaid expenses (7,738) (12,416) Unamortized aircraft maintenance 5,970 (24,608) Accounts payable (26,792) 5,661 Accrued liabilities (5,709) (31,668) Accrued incentive compensation (24,790) 647 Accrued claims costs 21,922 3,816 Income taxes (1,777) 48,572 Employee benefits 14,927 16,877 Aircraft lease return provision (14,457) (1,091) Deferred charges and credits (26) 28,286 Other (6,467) (3,702) Net Cash Provided by Operating Activities 172,151 120,494 INVESTING ACTIVITIES Capital expenditures (113,063) (111,183) Software expenditures (9,159) (11,022) Proceeds from sale of securities - 2,619 Proceeds from sales of property 1,006 6,223 Net Cash Used in Investing Activities (121,216) (113,363) FINANCING ACTIVITIES Proceeds from issuance of long-term debt - 197,452 Repayment of long-term debt, guarantees and capital leases (7,559) (96,455) Repayment of short-term borrowings, net - (40,000) Proceeds from exercise of stock options 2,234 707 Payments of common dividends (9,754) (9,702) Payments of preferred dividends (5,376) (5,470) Net Cash Provided by (Used in) Financing Activities (20,455) 46,532 Net Cash Provided by Continuing Operations 30,480 53,663 Net Cash Used in Discontinued Operations (3,525) (63,484) Increase (Decrease) in Cash and Cash Equivalents 26,955 (9,821) CASH AND CASH EQUIVALENTS, END OF PERIOD $ 131,470 $ 136,442 The accompanying notes are an integral part of these statements. PAGE 7 CNF INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. Principal Accounting Policies Basis of Presentation The accompanying consolidated financial statements of CNF Inc. (formerly CNF Transportation Inc.) and its wholly owned subsidiaries (the Company) have been prepared by the Company, without audit by independent public accountants, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the consolidated financial statements include all normal recurring adjustments necessary to present fairly the information required to be set forth therein. Certain information and note disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted from these statements pursuant to such rules and regulations and, accordingly, should be read in conjunction with the consolidated financial statements included in the Company's 2000 Annual Report to Shareholders. Recognition of Revenues As a result of recent pronouncements, including SEC Staff Accounting Bulletin No. 101, the Company elected to prospectively adopt, effective January 1, 2000, a change in accounting method for recognition of its freight transportation revenue to a preferable method. The Company now recognizes the allocation of freight transportation revenue between reporting periods based on relative transit time in each reporting period with expenses recognized as incurred. Previously, revenue was recognized when freight was received for shipment and the estimated costs of performing the transportation service were accrued. Reclassification Certain amounts in prior year financial statements have been reclassified to conform to current year presentation. 2. Discontinued Operations On November 3, 2000, Emery Worldwide Airlines (EWA) and the U.S. Postal Service (USPS) announced an agreement to terminate their contract for the transportation and sortation of Priority Mail (the "Priority Mail contract"). The contract was originally scheduled to terminate in the first quarter of 2002, subject to renewal options. Under terms of the agreement, the USPS on January 7, 2001, assumed operating responsibility for services covered under the contract, except certain air transportation and related services, which were terminated effective April 23, 2001. PAGE 8 The USPS agreed to reimburse EWA for Priority Mail contract termination costs, including costs of contract-related equipment, inventory, and operating lease commitments, up to $125 million (the "Termination Liability Cap"). On January 7, 2001, the USPS paid EWA $60 million toward the termination costs. The termination agreement provides for this provisional payment to be adjusted if actual termination costs are greater or less than $60 million, in which case either the USPS will be required to make an additional payment or EWA will be required to return a portion of the provisional payment. The termination agreement preserves EWA's right to pursue claims for underpayment that it believes are owed by the USPS under the Priority Mail contract and EWA has initiated litigation in the U.S. Court of Federal Claims for that purpose. These claims are to recover costs of operating under the contract as well as profit and interest thereon. As a result of the contract termination, the results of operations of EWA's Priority Mail contract have been segregated and classified as discontinued operations in the Statements of Consolidated Operations for all periods presented. Assets and liabilities have been reclassified in the Consolidated Balance Sheets from their historical classifications to separately reflect them as net assets of discontinued operations. Cash flows related to discontinued operations have been segregated and classified separately as net cash flows from discontinued operations in the Statements of Consolidated Cash Flows. The net assets of discontinued operations were as follows: (Dollars in thousands) June 30, December 31, 2001 2000 ---------- ----------- Current assets $ 12,882 $ 26,120 Property, plant and equipment, net - 66,316 Long-term receivables and other assets 169,599 184,348 ---------- ----------- Total assets of discontinued operations 182,481 276,784 ---------- ----------- Current liabilities 9,978 94,334 Long-term liabilities 63,685 77,157 ---------- ----------- Total liabilities of discontinued operations 73,663 171,491 ---------- ----------- Net assets of discontinued operations $ 108,818 $ 105,293 ========== =========== PAGE 9 The Priority Mail contract provided for the re-determination of prices paid to EWA, which gave rise to unbilled revenue. Unbilled revenue representing contract change orders or claims was included in revenue only when it was probable that the change order or claim would result in additional contract revenue and if the amount could be reliably estimated. Unbilled revenue represents the accrual of revenue sufficient only to recover costs and therefore does not include profit or interest on either unbilled revenue or profit. Any unbilled revenue that EWA does not recover would be written off and reflected in operating results for discontinued operations in the then current period. Any amount of litigation award in excess of unbilled revenue would be reflected as income from discontinued operations in the then current period. Accordingly, no operating profit was recognized in connection with the Priority Mail contract since the third quarter of 1999, when EWA filed a claim for proposed higher prices. As described above, no operating profit has been recognized in connection with the Priority Mail contract since the third quarter of 1999. Revenue of $10.2 million was recognized in the first quarter of 2001 for the period prior to the USPS assuming operating responsibility for services covered under the contract on January 7, 2001. Subsequent to January 7, 2001, no revenue was recognized under the Priority Mail contract. In the second quarter and first half of last year, revenue from the Priority Mail contract was $126.8 million and $262.0 million, respectively. As a result of the termination of the Priority Mail contract, a loss from discontinuance of $13.5 million was recognized in the third quarter of 2000, net of $8.6 million of income tax benefits. The loss from discontinuance included estimates for the write-down of non-reimbursable assets, legal and advisory fees, costs of providing transportation services for approximately three months following the effective termination date, certain employee-related costs and other non-reimbursable costs from discontinuance. The amount of accrued loss from discontinuance related to EWA's Priority Mail contract recognized at June 30, 2001 and December 31, 2000 was $1.1 million and $22.1 million, respectively, and was included in net current assets (liabilities) of discontinued operations in the Consolidated Balance Sheets. The amount of unbilled revenue and reimbursable contract termination costs related to EWA's Priority Mail contract recognized at June 30, 2001 and December 31, 2000 was $189.0 million and $176.2 million, respectively. Unbilled revenue and reimbursable termination costs at June 30, 2001 and December 31, 2000 were included in net non-current assets of discontinued operations in the Consolidated Balance Sheets. As described above, the Company is pursuing recovery of this amount plus profit and interest thereon. Long-term Receivables and Other Assets for the discontinued Priority Mail operations at June 30, 2001 has been reduced by certain payments received from the USPS in the first half of 2001. Unbilled revenue at June 30, 2001 and December 31, 2000 was reduced by a $102.1 million payment received from the USPS in the fourth quarter of 2000. The payment was based on rate adjustments resulting from a decision in August 2000 in the U.S. Court of Federal Claims under which the USPS increased its provisional rate paid to EWA for transportation and sortation of Priority Mail for 2000. The USPS also increased the provisional rate paid to EWA for 1999. PAGE 10 3. New Accounting Standards As described in Note 10 of the Notes to Consolidated Financial Statements, we adopted SFAS 133, "Accounting for Derivative Instruments and Hedging Activities" effective January 1, 2001. The $3.0 million cumulative effect of adopting the new accounting standard decreased Other Comprehensive Loss. In June 2001, the Financial Accounting Standards Board issued SFAS 141, "Business Combinations", effective July 1, 2001, and SFAS 142, "Goodwill and Other Intangible Assets", effective for CNF on January 1, 2002. SFAS 141 prohibits pooling-of-interests accounting for acquisitions. SFAS 142 specifies that goodwill and some intangible assets will no longer be amortized but instead will be subject to periodic impairment testing. The Company is in the process of evaluating the financial statement impact of adoption of SFAS 142. 4. Debt In July 2001, the Company entered into a new five-year $350 million unsecured revolving credit facility that replaced an existing five-year facility. The new revolving facility is available for cash borrowings and issuance of letters of credit. Borrowings under the agreement, which terminates on July 3, 2006, bear interest at a rate based upon specified indices plus a margin dependent on the Company's credit rating. The agreement contains various restrictive covenants, including a limitation on the incurrence of additional indebtedness and the requirement for specified levels of consolidated net worth and fixed-charge coverage. PAGE 11 5. Significant Unusual Items Emery Restructuring Charge On June 14, 2001, the Company announced an operational restructuring of Emery Worldwide's North American operations. The redesigned North American network is intended to restructure Emery's capacity to align with management's estimates of future business prospects for the domestic heavy airfreight segment. The air transportation provided by Emery Worldwide Airlines (EWA), a separate CNF subsidiary included in the Emery Worldwide reporting segment, is the primary cost component of the North American network. Emery's restructuring plan includes a redesign of the North American operations, revisions to service areas, and removing underutilized aircraft from service. These actions are designed to address changes in market conditions, which have deteriorated due to an adverse domestic economy, and to a lesser extent, loss of business to ground transportation providers and the recent loss of the Express Mail and Priority Mail contracts with the U.S. Postal Service. The $340.5 million restructuring charge consisted primarily of non- cash impairment charges, including $184.2 million for unamortized aircraft maintenance and $89.7 million for aircraft operating supplies, equipment and other assets. Asset impairment charges were based on an evaluation of cash flows for North American operations and, for certain assets, independent appraisal. Also included in the restructuring charge was $66.6 million for estimated future cash expenditures for aircraft lease rental, return and other obligations. As of June 30, 2001, no cash payments had been made to reduce the accrued aircraft lease obligations and return provision. The Company expects the timing of the payments will be based on the planned disposition dates of the aircraft. Menlo Write-Off Due to Failure of Customer On July 13, 2001, the Company announced that Menlo would take a write- off over two quarters due to the business failure of Homelife, a retail furniture business and customer of Menlo Logistics. The $31.6 million second-quarter charge in 2001, which was recorded in Operating Expenses, includes primarily the write-off of uncollectable accounts receivable. Menlo expects to recognize an additional loss of approximately $6 million in the third quarter of 2001, primarily for the write-off of uncollectable accounts receivable from revenue to be billed in the third quarter of 2001. Also, Menlo announced that it would lay-off approximately 400 full-time employees who worked on the Homelife account. PAGE 12 6. Comprehensive Income (Loss) Comprehensive Income (Loss), which is a measure of all changes in equity except those resulting from investments by owners and distributions to owners, was as follows: Three Months Ended Six Months Ended (Dollars in thousands) June 30, June 30, 2001 2000 2001 2000 --------- --------- --------- --------- Net income (loss) $(225,809) $ 45,764 $(210,252) $ 81,232 Other comprehensive income (loss) Cumulative effect of change in accounting for derivative instruments and hedging activities (Note 10) - - 3,005 - Change in fair value of cash flow hedges (Note 10) 175 - (2,621) - Foreign currency translation adjustments (3,096) (3,297) (4,570) (7,917) --------- --------- --------- --------- (2,921) (3,297) (4,186) (7,917) --------- --------- --------- --------- Comprehensive income (loss)$(228,730) $ 42,467 $(214,438) $ 73,315 ========= ========= ========= ========= The following is a summary of the components of Accumulated Other Comprehensive Loss: June 30, December 31, (Dollars in thousands) 2001 2000 ----------- ----------- Cumulative effect of change in accounting for derivative instruments and hedging activities (Note 10) $ 3,005 $ - Accumulated change in fair value of cash flow hedges (Note 10) (2,621) - Accumulated foreign currency translation adjustments (31,948) (27,378) Minimum pension liability adjustment (8,441) (8,441) ----------- ----------- Accumulated other comprehensive loss $ (40,005) $ (35,819) =========== =========== PAGE 13 7. Business Segments Selected financial information about the Company's continuing operations is shown below. The Company evaluates performance of the segments based on several factors. However, the primary measurement focus is based on segment operating results, excluding significant non-recurring and/or unusual items. The prior period has been reclassified to exclude discontinued operations. Three Months Ended Six Months Ended (Dollars in thousands) June 30, June 30, 2001 2000 2001 2000 ---------- ---------- ---------- ---------- Revenues Con-Way Transportation $ 489,386 $ 528,672 $ 958,587 $1,037,424 Emery Worldwide 530,205 637,138 1,113,495 1,241,122 Menlo Logistics 237,574 241,600 462,938 455,176 Other 7,718 10,275 16,920 25,527 ---------- ---------- ---------- ---------- 1,264,883 1,417,685 2,551,940 2,759,249 Intercompany Eliminations Con-Way Transportation (193) (250) (424) (598) Emery Worldwide (47) (7,517) (139) (13,766) Menlo Logistics (3,071) (3,049) (5,840) (6,722) Other (4,964) (5,723) (10,464) (15,123) ---------- ---------- ---------- ---------- (8,275) (16,539) (16,867) (36,209) External Revenues Con-Way Transportation 489,193 528,422 958,163 1,036,826 Emery Worldwide 530,158 629,621 1,113,356 1,227,356 Menlo Logistics 234,503 238,551 457,098 448,454 Other 2,754 4,552 6,456 10,404 ---------- ---------- ---------- ---------- $1,256,608 $1,401,146 $2,535,073 $2,723,040 ========== ========== ========== ========== Operating Income (Loss) before Significant Unusual Items Con-Way Transporation$ 42,431 $ 65,452 $ 79,166 $ 122,148 Emery Worldwide [1] (29,911) 12,861 (36,458) 19,685 Menlo Logistics 9,352 8,473 17,523 16,111 Other [2] (1,723) 345 (6,354) 656 ---------- ---------- ---------- ---------- $ 20,149 $ 87,131 $ 53,877 $ 158,600 ---------- ---------- ---------- ---------- Significant Unusual Items: Emery restructuring charge $ (340,531) $ - $ (340,531) $ - Menlo loss on failure of customer (31,605) - (31,605) - ---------- ---------- ---------- ---------- Operating Income (Loss) $ (351,987) $ 87,131 $ (318,259) $ 158,600 ========== ========== ========== ========== [1] For the three and six months ended June 30, 2001, results included a $4.7 million loss from a legal settlement on previously returned aircraft. [2] For the three and six months ended June 30, 2001, results included $1.7 million and $6.3 million, respectively, of operating losses related to startup costs for Vector SCM, a joint venture formed with General Motors in December 2000 that is accounted for under the equity method. PAGE 14 8. Earnings Per Share Basic earnings per share was computed by dividing net income (loss) from continuing operations before accounting change by the weighted-average common shares outstanding. The calculation for diluted earnings per share from continuing operations was calculated as shown below. For the three and six months ended June 30, 2001, convertible securities and stock options were anti-dilutive and were therefore excluded from the calculation of diluted earnings per share. Three Months Ended Six Months Ended (Dollars in thousands except June 30, June 30, per share data) 2001 2000 2001 2000 ---------- ---------- ---------- ---------- Earnings (Loss): Net income (loss) from Continuing Operations $ (227,888) $ 43,692 $ (214,371)$ 79,870 Add-backs: Dividends on Series B preferred stock, net of replacement funding - 377 - 706 Dividends on preferred securities of subsidiary trust, net of tax - 954 - 1,908 ---------- ---------- ---------- ---------- $ (227,888) $ 45,023 $ (214,371)$ 82,484 ---------- ---------- ---------- ---------- Shares: Basic shares (weighted-average common shares outstanding) 48,760,668 48,463,040 48,704,866 48,440,350 Stock option dilution - 320,860 - 358,774 Series B preferred stock - 4,452,984 - 4,452,984 Preferred securities of subsidiary trust - 3,125,000 - 3,125,000 ---------- ---------- ---------- ---------- 48,760,668 56,361,884 48,704,866 56,377,108 ---------- ---------- ---------- ---------- Diluted Earnings (Loss) Per Share from Continuing Operations before Accounting Change $ (4.67) $ 0.80 $ (4.40)$ 1.46 ========== ========== ========== ========== 9. Preferred Securities of Subsidiary Trust On June 11, 1997, CNF Trust I (the Trust), a Delaware business trust wholly owned by the Company, issued 2,500,000 of its $2.50 Term Convertible Securities, Series A (TECONS) to the public for gross proceeds of $125 million. The combined proceeds from the issuance of the TECONS and the issuance to the Company of the common securities of the Trust were invested by the Trust in $128.9 million aggregate principal amount of 5% convertible subordinated debentures due June 1, 2012 (the Debentures) issued by the Company. The Debentures are the sole assets of the Trust. Holders of the TECONS are entitled to receive cumulative cash distributions at an annual rate of $2.50 per TECONS (equivalent to a rate of 5% per annum of the stated liquidation amount of $50 per TECONS). The Company has guaranteed, on a subordinated basis, distributions and other payments due on the TECONS, to the extent the Trust has funds available therefore and subject to certain other limitations (the Guarantee). The Guarantee, when taken together with the obligations of the Company under the Debentures, the Indenture pursuant to which the Debentures were issued, and the Amended and Restated Declaration of Trust of the Trust including its obligations to pay costs, fees, expenses, debts and other obligations of the Trust (other than with respect to the TECONS and the common securities of the Trust), provide a full and unconditional guarantee of amounts due on the TECONS. PAGE 15 The Debentures are redeemable for cash, at the option of the Company, in whole or in part, on or after June 1, 2000, at a price equal to 103.125% of the principal amount, declining annually to par if redeemed on or after June 1, 2005, plus accrued and unpaid interest. In certain circumstances relating to federal income tax matters, the Debentures may be redeemed by the Company at 100% of the principal plus accrued and unpaid interest. Upon any redemption of the Debentures, a like aggregate liquidation amount of TECONS will be redeemed. The TECONS do not have a stated maturity date, although they are subject to mandatory redemption upon maturity of the Debentures on June 1, 2012, or upon earlier redemption. Each TECONS is convertible at any time prior to the close of business on June 1, 2012, at the option of the holder into shares of the Company's common stock at a conversion rate of 1.25 shares of the Company's common stock for each TECONS, subject to adjustment in certain circumstances. 10. Derivative Instruments and Hedging Activities Effective January 1, 2001, the Company adopted SFAS 133, "Accounting for Derivative Instruments and Hedging Activities," as amended by SFAS 137 and SFAS 138. SFAS 133 establishes accounting and reporting standards requiring that every derivative instrument, as defined, be recorded on the balance sheet as either an asset or liability measured at fair value and that changes in fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Qualifying hedges allow a derivative's gains or losses to offset related results on the hedged item in the income statement or be deferred in Other Comprehensive Income (Loss) until the hedged item is recognized in earnings. The Company is exposed to a variety of market risks, including the effects of interest rates, commodity prices, foreign currency exchange rates and credit risk. The Company's policy is to enter into derivative financial instruments only in circumstances that warrant the hedge of an underlying asset, liability or future cash flow against exposure to the related risk. Additionally, the designated hedges should have high correlation to the underlying exposure such that fluctuations in the value of the derivatives offset reciprocal changes in the underlying exposure. The Company's policy prohibits entering into derivative instruments for speculative purposes. The Company formally documents its hedge relationships, including identifying the hedge instruments and hedged items, as well as its risk management objectives and strategies for entering into the hedge transaction. At hedge inception and at least quarterly thereafter, the Company assesses whether the derivatives are effective in offsetting changes in either the cash flows or fair value of the hedged item. If a derivative ceases to be a highly effective hedge, the Company will discontinue hedge accounting, and any gains or losses on the derivative instrument would be recognized in earnings during the period it no longer qualifies for hedge accounting. PAGE 16 For derivatives designated as cash flow hedges, changes in the derivative's fair value are recognized in Other Comprehensive Income (Loss) until the hedged item is recognized in earnings. Any change in fair value resulting from ineffectiveness is recognized immediately in earnings. For derivatives designated as fair value hedges, changes in the derivative's fair value are recognized in earnings and offset by changes in the fair value of the hedged item, which are recognized in earnings to the extent that the derivative is effective. The Company's cash flow hedges include interest rate swap derivatives designated to mitigate the effects of interest rate volatility on floating- rate operating lease payments. Fair value hedges include interest rate swap derivatives designated to mitigate the effects of interest rate volatility on the fair value of fixed-rate long-term debt. The Company's current interest rate swap derivatives qualify for hedge treatment under SFAS 133. In accordance with the transition provisions of SFAS 133, the Company recorded in Other Assets a transition adjustment of $20.6 million to recognize the estimated fair value of interest rate swap derivatives, a $4.9 million ($3.0 million after tax) transition adjustment in Accumulated Other Comprehensive Income (Loss) to recognize the estimated fair value of interest rate swap derivatives designated as cash flow hedges, and a $15.7 million transition adjustment in Long-Term Debt to recognize the difference between the carrying value and estimated fair value of fixed-rate debt hedged with interest rate swap derivatives designated as fair value hedges. In the second quarter and first half of 2001, the change in the estimated fair value of the Company's fair value hedges declined $4.9 million and $0.5 million, respectively. The estimated fair value of cash flow hedges in the second quarter of 2001 increased $287,000 ($175,000 after tax) and declined $4.3 million ($2.6 million after tax) in the first half of 2001. 11. Commitments and Contingencies The Company is currently under examination by the Internal Revenue Service (IRS) for tax years 1987 through 1999 on various issues. In connection with those examinations, the IRS proposed adjustments for tax years 1987 through 1990 after which the Company filed a protest and engaged in discussions with the Appeals Office of the IRS. After those discussions failed to produce a settlement, in March 2000, the IRS issued a Notice of Deficiency (the Notice) for the years 1987 through 1990 with respect to various issues, including aircraft maintenance and matters related to years prior to the spin-off of Consolidated Freightways Corporation (CFC), the Company's former long-haul LTL segment, on December 2, 1996. Based upon the Notice, the total amount of the deficiency for items in years 1987 through 1990, including taxes and interest, was $157 million as of June 30, 2001. The amount originally due under the Notice was reduced in the third quarter of 2000 by a portion of the Company's $93.4 million payment to the IRS, which is described below. In addition to the issues covered under the Notice for tax years 1987 through 1990, the IRS in May 2000 proposed additional adjustments for tax years 1991 through 1996 with respect to various issues, including aircraft maintenance and matters relating to CFC for years prior to the spin-off. Under the Notice, the IRS has assessed a substantial adjustment for tax years 1989 and 1990 based on the IRS' position that certain aircraft maintenance costs should have been capitalized rather than expensed for federal income tax purposes. The Company believes that its practice of expensing these types of aircraft maintenance costs is consistent with industry practice and the recently issued Treasury Ruling 2001-4. The Company intends to vigorously contest the Notice and the proposed adjustments as they pertain to the aircraft maintenance issue. PAGE 17 The Company paid $93.4 million to the IRS in the third quarter of 2000 to stop the accrual of interest on amounts due under the Notice for tax years 1987 through 1990 and under proposed adjustments for tax years 1991 through 1996 for matters relating to CFC for years prior to the spin-off and for all other issues except aircraft maintenance costs. There can be no assurance that the Company will not be liable for all of the amounts due under the Notice and proposed adjustments. As a result, the Company is unable to predict the ultimate outcome of this matter and there can be no assurance that this matter will not have a material adverse effect on the Company's financial condition or results of operations. As part of the spin-off, the Company and CFC entered into a tax sharing agreement that provided a mechanism for the allocation of any additional tax liability and related interest that arise due to adjustments by the IRS for years prior to the spin-off. In May 2000, the Company and CFC settled certain federal tax matters relating to CFC on issues for tax years 1984 through 1990. Under the settlement agreement, the Company received from CFC cash of $16.7 million, a $20.0 million note due in 2004, and a commitment to transfer to the Company land and buildings with an estimated value of $21.2 million. In the last half of 2000, the Company received real property with an estimated value of $21.2 million in settlement of CFC's commitment to transfer land and buildings. Prior to its transfer, the real property collateralized CFC's obligation to the Company. In March 2001, the Company entered into an agreement to acquire real property owned by CFC in settlement of CFC's $20.0 million note due in 2004. The agreement requires a three-way exchange among the Company, CFC and a third party. In March 2001, the Company acquired real property, which was previously owned by CFC, from a third party in exchange for a note payable. Under the agreement, the Company will pay in full the note payable due to the third party while concurrently receiving an approximately equal amount of cash from CFC in settlement of the Company's $20.0 million note receivable due from CFC. If CFC's third party exchange transaction does not close by late September 2001, the Company has the right to tender the $20.0 million CFC note in exchange for the Company's note payable. At June 30, 2001, the third-party note payable and the CFC note receivable were included in Accrued Liabilities and Other Accounts Receivable, respectively, in the Consolidated Balance Sheets. In connection with the spin-off of CFC, the Company agreed to indemnify certain states, insurance companies and sureties against the failure of CFC to pay certain worker's compensation, tax and public liability claims that were pending as of September 30, 1996. In some cases, these indemnities are supported by letters of credit under which the Company is liable to the issuing bank and by bonds issued by surety companies. In order to secure CFC's obligation to reimburse and indemnify the Company against liability with respect to these claims, CFC had provided the Company with certain letters of credit. However, the letters of credit have been terminated, and as of June 30, 2001, CFC's reimbursement obligations to the Company were unsecured. In addition to the matters discussed above, the Company and its subsidiaries are defendants in various lawsuits incidental to their businesses. It is the opinion of management that the ultimate outcome of these actions will not have a material impact on the Company's financial condition or results of operations. PAGE 18 PART I. FINANCIAL INFORMATION ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Unusual Items On June 14, 2001, we announced an operational restructuring of Emery Worldwide's North American operations. The redesigned North American network is intended to restructure Emery's capacity to align with management's estimates of future business prospects for the domestic heavy airfreight segment. The air transportation provided by Emery Worldwide Airlines (EWA), a separate CNF subsidiary included in the Emery Worldwide reporting segment, is the primary cost component of the North American network. The $340.5 million restructuring charge ($4.26 per diluted share) is described below in the Emery Worldwide segment. In addition to the restructuring charge, Emery in June 2001 also incurred a $4.7 million loss ($0.06 per diluted share) from a legal settlement on previously returned aircraft. On July 13, 2001, we announced that Menlo Logistics would take a write- off over two quarters due to the business failure of Homelife, a retail furniture business and customer of Menlo. The $31.6 million second-quarter charge in 2001 ($0.40 per diluted share), primarily the write-off of uncollectable accounts receivable, is described below in the Menlo Logistics segment. RESULTS OF OPERATIONS ===================== Net losses applicable to common shareholders of $227.9 million ($4.67 per diluted share) in the second quarter of 2001 and $214.4 million ($4.40 per diluted share) in the first half of 2001 include the unusual items described above. The significant charges contributed to an effective tax benefit rate of 37.0% for the first half of 2001. Excluding unusual items, net income applicable to common shareholders for the second quarter and first half of 2001 was $8.2 million and $21.7 million, respectively, based on an effective tax rate of 40.0%. In the second quarter of last year, net income applicable to common shareholders was $43.7 million ($0.80 per diluted share). Last year's first-half net income applicable to common shareholders of $77.1 million ($1.41 per diluted share) included a $2.6 million net gain ($0.03 per diluted share) from the sale of securities and a $2.7 million net-of-tax loss from the cumulative effect of an accounting change. Excluding unusual items, the decline in net income applicable to common shareholders in the second quarter and first half of 2001, compared to the same periods last year, was due primarily to lower operating income and higher other net expenses. Revenue in the second quarter and first half of 2001 fell 10.3% and 6.9% from the respective periods last year due primarily to declines in revenue from Con-Way and Emery. We believe that revenue from all reporting segments in the second quarter and first half of 2001 was adversely affected by the continuing downturn in the U.S. economy. The operating loss in the second quarter and first half of 2001 was $352.0 million and $318.3 million, respectively. Excluding unusual items, operating income in the second quarter of 2001 declined to $24.8 million from $87.1 million in the same quarter last year and operating income in the first half of 2001 declined to $58.6 million from $158.6 million in last year's first half. The drop in second-quarter and first-half operating income in 2001 was due primarily to lower operating income from all reporting segments except Menlo. Excluding the loss on the failure of Homelife, Menlo's 2001 second-quarter and first-half operating income rose 10.4% and 8.8%, respectively, over the same periods in 2000. PAGE 19 Other net expense in the second quarter of 2001 increased 1.8% from last year's second quarter due primarily to a decline in miscellaneous income, partially offset by an 8.2% decline in interest expense. Lower interest expense in the 2001 second quarter was due in part to lower interest expense on long-term debt, which was effectively converted from a fixed rate to a floating rate with interest rate swaps entered into in April 2000. Other net expense in the first half of 2001 rose 23.2% due primarily to a 5.2% increase in interest expense and a $2.6 million net gain from the sale of securities in the first quarter of last year. The increase in interest expense in the first half of 2001 was due primarily to higher interest expense on $200 million of 8 7/8% Notes issued in March 2000, partially offset by an increase in income from the interest rate swaps that hedge the 8 7/8% Notes and higher capitalized interest compared to the first half of last year. The effective tax benefit rate in the second quarter and first half of 2001 of 37.2% and 37.0%, respectively, was revised from the effective tax rate in 2001 of 42.5% in the second quarter and first half of 2000 due primarily to the significant unusual charges recognized in June 2001. Con-Way Transportation Services Revenue from Con-Way Transportation Services in the second quarter and first half of 2001 fell 7.4% and 7.6% from the respective periods last year. The regional carriers' revenue per hundredweight (yield) in the second quarter and first half of 2001 increased slightly, rising 0.6% and 1.7%, respectively, over last year's second quarter and first half. LTL tonnage per day (weight) for the same periods fell 3.3% and 3.4%, respectively, and total weight fell 3.9% for the same second-quarter and first-half periods last year. Con-Way's management believes that tonnage declines in the second quarter and first half of 2001 were primarily due to the continuing downturn in the U.S. economy. Also, Con-Way Truckload Services, which was sold in August 2000, accounted for revenue of $26.0 million and $50.0 million in last year's second quarter and first six months, respectively. Yield in the second quarter and first half of 2001 was positively affected by a higher percentage of inter-regional joint services, which typically command higher rates on longer lengths of haul, and, to a lesser extent, fuel surcharges. Con-Way's second-quarter and first-half operating income in 2001 declined 35.2% from the same periods in 2000 due primarily to lower revenue, higher employee benefit expenses and an increase in costs for vehicular claims. Higher diesel fuel costs in the second quarter and first half of 2001 were mitigated by Con-Way's fuel surcharge. The second quarter and first half of 2001 were adversely affected by higher losses from Con-Way Logistics (formerly Con-Way Integrated Services) compared to the same periods last year and operating losses incurred during the start- up of Con-Way Air Express, a domestic air freight forwarding company that began operations in May 2001. Emery Worldwide In June 2001, we announced an operational restructuring of Emery Worldwide's North American operations. The redesigned North American network is intended to restructure Emery's capacity to align with management's estimates of future business prospects for the domestic heavy airfreight segment. The air transportation provided by Emery Worldwide Airlines (EWA), a separate CNF subsidiary included in the Emery Worldwide reporting segment, is the primary cost component of the North American network. PAGE 20 Emery's restructuring plan includes a redesign of the North American operations, revisions to service areas, and the parking of underutilized aircraft. These actions are designed to address changes in market conditions, which have deteriorated due to an adverse domestic economy, and to a lesser extent, loss of business to ground transportation providers and the recent loss of the Express Mail and Priority Mail contracts with the U.S. Postal Service. The $340.5 million restructuring charge consisted primarily of non- cash impairment charges, including $184.2 million for unamortized aircraft maintenance and $89.7 million for aircraft operating supplies, equipment and other assets. Asset impairment charges were based on an evaluation of cash flows for North American operations and, for certain assets, independent appraisal. Also included in the restructuring charge was $66.6 million for estimated future cash expenditures for aircraft lease rental, return and other obligations. As of June 30, 2001, no cash payments had been made to reduce the accrued aircraft lease obligations and return provision. The Company expects the timing of the payments will be based on the planned disposition dates of the aircraft. Emery's management intends to continue to pursue aggressive growth in its "asset-light" businesses, such as international air and ocean forwarding, customs brokerage, logistics management and expedited delivery services. In its North American airfreight business, Emery's management intends to continue positioning Emery as a premium service provider, focusing on achieving higher yield with a reduced cost structure. With its redesigned North American network, Emery's management intends to focus on increasing revenue from second-day and deferred services. Internationally, Emery's management will focus on expanding its variable-cost-based operations and actively renegotiating airhaul rates in an effort to improve operating margins, mitigate higher fuel prices, and balance directional capacity. In the second quarter and first half of 2001, Emery's revenue declined 15.8% and 9.3%, respectively, from the same periods last year due primarily to lower North American and International airfreight revenue and lower revenue from an Express Mail contract with the U.S. Postal Service. International airfreight revenue per day in the second quarter and first half of 2001, including fuel surcharges, fell 11.8% and 5.4%, respectively, from the same periods last year due primarily to a decline in pounds transported per day (weight), partially offset by higher revenue per pound (yield). Second-quarter and first-half International yield in 2001 increased 1.7% and 4.5%, respectively, from last year's second quarter and first half. International weight over the same period declined 13.3% and 8.8%, respectively. Emery's management believes that lower international weight in the second quarter and first half of 2001 was due in part to a worsening global economy, which adversely affected business levels in Latin America, Asia and other international markets served by Emery. North American second-quarter and first-half airfreight revenue per day, including fuel surcharges, declined 23.9% and 18.5%, respectively, from the same periods last year. Although North American airfreight yield in the second quarter and first half of 2001 increased 7.8% and 8.7%, respectively, over the second quarter and first half of 2000, weight per day over the same periods declined 29.4% and 24.5%, respectively. The 2001 second-quarter and first-half decline in North American weight was attributable in part to lower business levels from the manufacturing industry, particularly the automotive and technology sectors. Emery's management believes that the lower business levels in the first two quarters of 2001 were adversely affected by the continuing downturn in the U.S. economy and, to a lesser extent, loss of business to ground transportation providers and Emery's ongoing yield management, which is designed to eliminate or reprice certain low-margin business. Yields in the second quarter and first half of 2001 were positively affected by an increase in the percentage of higher-yielding guaranteed services and Emery's ongoing yield management efforts. PAGE 21 Emery's operating loss in the second quarter and first half of 2001 was $370.4 million and $377.0 million, respectively. The second-quarter and first-half operating loss for Emery in 2001, excluding the restructuring charge and loss from a legal settlement on returned aircraft, was $25.2 million and $31.8 million, respectively. In the same periods last year, Emery earned operating income of $12.9 million and $19.7 million, respectively. The decline in operating results in the second quarter and first half of 2001 was primarily due to lower North American and International airfreight revenue, lower revenue from the Express Mail contract referred to below; an increase in North American airhaul costs as a percentage of revenue, and higher employee benefit costs. Higher jet fuel costs in the first two quarters of 2001 were mitigated by Emery's fuel surcharge. In January 2001, the USPS and Federal Express Corporation (FedEx) announced an exclusive agreement under which FedEx will transport Express Mail and Priority Mail. EWA presently transports Express Mail and other classes of mail under a contract with the USPS scheduled to expire in January 2004, (the "Express Mail Contract"). In January 2001, EWA filed a lawsuit in the U.S. Court of Federal Claims against the USPS, alleging that the contract with FedEx violates the USPS procurement regulations, which require that all purchases over $10,000 "must be made on the basis of adequate competition whenever feasible or appropriate," and that the contract violates the USPS regulatory requirement to provide "fair and equal treatment" to all potential suppliers. The Court ruled against EWA. The matter is now on appeal. In May 2001, EWA received from the USPS a notice of termination for convenience of the Express Mail Contract, effective as of August 26, 2001. In the second quarter and first half of 2001, EWA recognized revenue of $41.9 million and $89.4 million, respectively, from the transportation of the Express Mail Contract, compared to $49.4 million and $99.8 million in the respective periods last year. Operating income from the Express Mail contract in the second quarter and first half of 2001 was just $64,000 and $3.6 million, respectively, compared to $5.5 million and $11.6 million, respectively, in the same periods last year. EWA believes it is entitled to its costs of early termination of the Express Mail Contract. The USPS's early termination of the Express Mail Contract will likely have a material adverse effect on our consolidated results of operations and financial condition. Menlo Logistics In July 2001, we announced that Menlo would take a write-off over two quarters due to the business failure of Homelife, a retail furniture business and customer of Menlo. The $31.6 million second-quarter charge in 2001, which was recorded in Operating Expenses, includes primarily the write-off of uncollectable accounts receivable. Menlo expects to recognize an additional loss of approximately $6 million in the third quarter of 2001, primarily for the write-off of uncollectable accounts receivable from revenue to be billed in the third quarter of 2001. Also, Menlo announced that it would lay-off approximately 400 fulltime employees who worked on the Homelife account. In the second quarter and first half of 2001, Menlo recognized revenue from Homelife of $27.4 million and $45.4 million, respectively, compared to $3.7 million for both the second quarter and first half of last year. Excluding Menlo's significant charge, operating income earned by Menlo from the Homelife account in the second quarter and first half of 2001 was $0.6 million and $2.6 million, respectively, compared to $1.1 million earned from Homelife in both the second quarter and first half of last year. PAGE 22 Menlo's second-quarter revenue in 2001 declined 1.7% from last year's second quarter and first-half revenue in 2001 increased 1.9% from the same period in 2000 due to growth in logistics contracts and consulting fees, including higher revenue from the Homelife account. Menlo's management believes that the continuing downturn in the U.S. economy had an adverse effect on business levels of some of its other customers but the resulting adverse effect on Menlo's revenue was partially mitigated by Menlo's ability to secure new logistics contracts. A portion of Menlo's revenue is attributable to logistics contracts for which Menlo manages the transportation of freight but subcontracts the actual transportation and delivery of products to third parties. Menlo refers to this as purchased transportation. Menlo's net revenue (revenue less purchased transportation) in the second quarter and first half of 2001 was $70.3 million and $137.7 million, respectively, compared to $65.1 million and $130.1 million in the respective periods last year. Menlo's operating loss in the second quarter and first half of 2001 was $22.3 million and $14.1 million. Excluding the loss on the failure of Homelife, Menlo's 2001 second-quarter and first-half operating income rose 10.4% and 8.8%, respectively, over the same periods in 2000 due primarily to increased revenue from core supply chain projects and consulting fees. Other Operations In the second quarter and first half of 2001, the Other segment included the operating results of Road Systems and Vector SCM, a joint venture formed with General Motors in December 2000 to provide logistics services to General Motors. The operating results of Vector SCM are reported as an equity investment in the Other segment. Operating losses related to the start-up of Vector SCM in the second quarter and first half of 2001 were $1.7 million and $6.3 million, respectively. Discontinued Operations ----------------------- On November 3, 2000, EWA and the USPS announced an agreement to terminate their contract for the transportation and sortation of Priority Mail. Under terms of the agreement, the USPS on January 7, 2001 assumed operating responsibility for services covered under the contract, except certain air transportation and related services, which were terminated effective April 23, 2001. Accordingly, the results of operations, net assets, and cash flows of the Priority Mail operations have been segregated and classified as discontinued operations. A summary of selected terms of the agreement, summary financial data, and related information are included in Note 2 of the Notes to Consolidated Financial Statements. PAGE 23 The USPS agreed to reimburse EWA for Priority Mail contract termination costs, including costs of contract-related equipment, inventory, and operating lease commitments, up to $125 million (the "Termination Liability Cap"). On January 7, 2001, the USPS paid EWA $60 million toward the termination costs. The termination agreement provides for this provisional payment to be adjusted if actual termination costs are greater or less than $60 million, in which case either the USPS will be required to make an additional payment or EWA will be required to return a portion of the provisional payment. We believe that contract termination costs incurred by EWA are reimbursable under the termination agreement and do not exceed the Termination Liability Cap. However, there can be no assurance that all termination costs incurred by Emery will be recovered. The termination agreement preserves EWA's right to pursue claims for underpayment that it believes are owed by the USPS under the Priority Mail contract and EWA has initiated litigation in the U.S. Court of Federal Claims for that purpose. These claims are to recover costs of operating under the contract as well as profit and interest thereon. The amount of unbilled revenue and reimbursable contract termination costs related to EWA's Priority Mail contract recognized at June 30, 2001 and December 31, 2000 was $189.0 million and $176.2 million, respectively. Unbilled revenue represents the accrual of revenue sufficient only to recover costs and therefore does not include profit or interest on either unbilled revenue or profit. Any unbilled revenue that EWA does not recover would be written off and reflected in operating results for discontinued operations in the then current period. Any amount of litigation award in excess of unbilled revenue would be reflected as income from discontinued operations in the then current period. We believe our position with respect to claims for underpayment under the Priority Mail contract is reasonable and well founded; however, there can be no assurance that litigation will result in an award sufficient to recover unbilled revenue recognized under the contract or any award at all. The government is investigating matters relating to the Priority Mail contract, and EWA has received subpoenas for documents from a grand jury in Massachusetts and the USPS Inspector General. Accordingly, we can give no assurance that matters relating to the Priority Mail contract with the USPS will not have a material adverse effect on our financial condition or results of operations. LIQUIDITY AND CAPITAL RESOURCES =============================== Continuing Operations --------------------- In the first half of 2001, cash and cash equivalents increased $27.0 million to $131.5 million. Cash provided by operating activities in the 2001 first half was sufficient to fund investing and financing activities. Operating activities in the 2001 first half generated net cash of $172.2 million compared to $120.5 million of cash generated by operating activities in the same period last year. Cash from operations in the first half of 2001 was provided primarily by depreciation and amortization, which are adjustments to reconcile net income (loss) to net cash provided by operating activities, and the collection of receivables. Positive cash flow was also provided by net income before the significant non-cash charges described in "Results of Operations" and the related tax effect, which contributed to a significant decline in deferred taxes. Positive operating cash flows in the first half of 2001 were partially offset by a decline in accounts payable and accrued incentive compensation. PAGE 24 Investing activities in the first half of 2001 consumed $121.2 million compared to $113.4 million used in the first half of last year. Capital expenditures of $113.1 million in the 2001 first half increased slightly from $111.2 million in last year's first half due primarily to a $22.3 million increase in Con-Way's capital expenditures, partially offset by a $17.0 million reduction at Emery. Higher capital expenditures from Con-Way were primarily due to $53.2 million of cash spent for the planned periodic replacement of linehaul equipment. In the first half of last year, Con-Way financed the acquisition of $50.7 million of equipment with operating leases. Financing activities in the first half of 2001 used cash of $20.5 million compared to first-half financing activities that provided $46.5 million last year. In the first half of last year, a portion of the net proceeds of $197.5 million from the issuance in March 2000 of $200 million of 8 7/8% Notes due 2010 were used to repay short-term and long-term borrowings outstanding under lines of credit. In July 2001, we entered into a new five-year $350 million unsecured revolving credit facility that replaced an existing five-year facility completed in 1996. The new revolving facility matures July 3, 2006 and is also available for the issuance of letters of credit. At June 30, 2001, no borrowings were outstanding under the existing $350 million facility and $62.5 million of letters of credit were outstanding, leaving available capacity of $287.5 million. Also, at June 30, 2001, we had $100.0 million of uncommitted lines with no outstanding borrowings. Under other unsecured facilities, $83.5 million in letters of credit and bank guarantees were outstanding at June 30, 2001. Our ratio of total debt to capital increased to 36.3% at June 30, 2001 from 31.4% at December 31, 2000 due primarily to the significant unusual charges described in "Results of Operations". Discontinued Operations ----------------------- As described above under "Results of Operations," cash flows from the Priority Mail operations have been segregated and classified as net cash flows from discontinued operations in the Statements of Consolidated Cash Flows. As described in Note 2 of the Notes to Consolidated Financial Statements, EWA in January 2001 received a $60 million provisional payment toward reimbursable termination costs, as provided under a termination agreement signed by EWA and the USPS in November 2000. CYCLICALITY AND SEASONALITY =========================== Our businesses operate in industries that are affected directly by general economic conditions and seasonal fluctuations, both of which affect demand for transportation services. In the trucking and airfreight industries, for a typical year, the months of September and October usually have the highest business levels while the months of January and February usually have the lowest business levels. MARKET RISK =========== We are exposed to a variety of market risks, including the effects of interest rates, commodity prices, foreign currency exchange rates and credit risk. Our policy is to enter into derivative financial instruments only in circumstances that warrant the hedge of an underlying asset, liability or future cash flow against exposure to some form of commodity, interest rate or currency-related risk. Additionally, the designated hedges should have high correlation to the underlying exposure such that fluctuations in the value of the derivatives offset reciprocal changes in the underlying exposure. Our policy prohibits entering into derivative instruments for speculative purposes. PAGE 25 We may be exposed to the effect of interest rate fluctuations in the fair value of our long-term debt and capital lease obligations, as summarized in Notes 4 and 5 of our consolidated financial statements included in our 2000 Annual Report to Shareholders. As described in Note 10 of the Notes to Consolidated Financial Statements, we use interest rate swaps to mitigate the impact of interest rate volatility on cash flows related to operating lease payments and on the fair value of our fixed-rate long-term debt. At June 30, 2001, we had not entered into any derivative contracts to hedge our foreign currency exchange exposure. ACCOUNTING STANDARDS ==================== As described in Note 10 of the Notes to Consolidated Financial Statements, we adopted SFAS 133, "Accounting for Derivative Instruments and Hedging Activities" effective January 1, 2001. The $3.0 million cumulative effect of adopting the new accounting standard decreased Other Comprehensive Loss. In the second quarter and first half of 2001, the decline in the estimated fair value of our fair value hedges of $4.9 million and $0.5 million, respectively, resulted in reductions to Other Assets and Long-Term Debt. During the second quarter of 2001, the estimated fair value of cash flow hedges increased $287,000 ($175,000 net of tax). In the first half of 2001, the estimated fair value of cash flow hedges declined $4.3 million ($2.6 million net of tax). Changes in the estimated fair value of cash flow hedges were included in Other Assets and Other Comprehensive Income (Loss). In June 2001, the Financial Accounting Standards Board issued SFAS 141, "Business Combinations", effective July 1, 2001, and SFAS 142, "Goodwill and Other Intangible Assets", effective for CNF on January 1, 2002. SFAS 141 prohibits pooling-of-interests accounting for acquisitions. SFAS 142 specifies that goodwill and some intangible assets will no longer be amortized but instead will be subject to periodic impairment testing. The Company is in the process of evaluating the financial statement impact of adoption of SFAS 142. PAGE 26 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings As previously reported, the Company has been designated a potentially responsible party (PRP) by the EPA with respect to the disposal of hazardous substances at various sites. The Company expects its share of the clean-up costs will not have a material adverse effect on the Company's financial condition or results of operations. The Department of Transportation, through its Office of Inspector General, and the Federal Aviation Administration has been conducting an investigation relating to the handling of so-called hazardous materials by Emery. The Department of Justice has joined in the investigation and is seeking to obtain additional information through the grand jury process. The investigation is ongoing and Emery is cooperating fully. The Company is unable to predict the outcome of this investigation. EWA has received subpoenas issued by a grand jury in Massachusetts and the USPS Inspector General for documents relating to the Priority Mail contract. EWA has provided, or is in the process of providing, the documents. On February 16, 2000, a DC-8 cargo aircraft operated by EWA personnel crashed shortly after take-off from Mather Field, near Sacramento, California. The crew of three was killed. The cause of the crash has not been conclusively determined. The National Transportation Safety Board is conducting an investigation and has scheduled a public hearing for August 22 and 23, 2001. The Company is currently unable to predict the outcome of this investigation or the effect it may have on Emery or the Company. Emery, EWA and the Company have been named as defendants in wrongful death lawsuits brought by the families of the three deceased crew members, seeking compensatory and punitive damages. Emery, EWA and the Company also may be subject to other claims and proceedings relating to the crash, which could include other private lawsuits seeking monetary damages and governmental proceedings. Although Emery, EWA and the Company maintain insurance that is intended to cover claims that may arise in connection with an airplane crash, there can be no assurance that the insurance will in fact be adequate to cover all possible types of claims. In particular, any claims for punitive damages or any sanctions resulting from possible governmental proceedings would not be covered by insurance. As a domestic airline, EWA operates under a certificate issued by the Federal Aviation Administration ("FAA"). As such, EWA is subject to maintenance, operating and other safety-related regulations promulgated by the FAA, and routinely undergoes FAA inspections. Based on recent inspections, the FAA has identified a number of instances where it believes EWA has failed to comply with applicable regulations, and in some cases has issued notices of proposed civil penalties. EWA disagrees with certain of the FAA's findings, and is engaged in discussions with the FAA to try to resolve the matters in dispute. However, there can be no assurance that EWA will be able to reach agreement with the FAA on all matters in dispute, and if no agreement is reached, the FAA may seek to impose sanctions on EWA. The FAA has the authority to seek civil and criminal penalties and to suspend or revoke an airline's operating certificate. Emery and the Company had been named as defendants in a lawsuit arising from a dispute with an aircraft lessor regarding the return of six McDonnell Douglas DC-8 aircraft following lease termination. Plaintiff was seeking damages in the amount of approximately $16 million, in addition to holdover rent and interest. This suit was dismissed after Emery agreed to pay certain holdover rent and make certain repairs to the aircraft before returning them to the lessor. PAGE 27 Con-Way and the Company have been named as defendants in a class action lawsuit filed in Federal District Court in San Francisco for alleged violations of federal and state wage and hour laws regarding classification of freight operations supervisors for purposes of overtime pay. No motion has yet been made for certification of the class. Because the lawsuit is at a preliminary stage, the Company is unable to predict the outcome of this litigation or the effect it may have on Con-Way or the Company. ITEM 6. Exhibits and Reports on Form 8-K (a) Exhibits 99(a) Computation of Ratios of Earnings (Loss) to Fixed Charges -- the ratios of earnings to fixed charges were -6.3x and 3.9x for the six months ended June 30, 2001 and 2000, respectively. (b) Computation of Ratios of Earnings (Loss) to Combined Fixed Charges and Preferred Stock Dividends -- the ratios of earnings to combined fixed charges and preferred stock dividends were -5.9x and 3.7x for the six months ended June 30, 2001 and 2000, respectively. (b)Reports on Form 8-K No reports on Form 8-K were filed during the quarter ended June 30, 2001. SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Company (Registrant) has duly caused this Form 10-Q Quarterly Report to be signed on its behalf by the undersigned, thereunto duly authorized. CNF Inc. (Registrant) August 9, 2001 /s/Greg Quesnel Greg Quesnel President, Chief Executive Officer and Chief Financial Officer