Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations.

NORFOLK SOUTHERN CORPORATION AND SUBSIDIARIES

Management's Discussion and Analysis of Financial Condition and Results of Operations

RESULTS OF OPERATIONS

Overview

Second-quarter net income was $213 million in 2004, compared with $137 million in 2003.   The increase was primarily the result of a $127 million, or 43%, increase in income from railway operations, which was driven by an 11% rise in revenues.   Railway operating expenses rose only 4% despite an 8% increase in carloads, reflecting increased operating leverage as the railroad network remained fluid.

For the first six months, net income was $371 million in 2004, compared with $346 million in 2003.   The following table shows the components of the change:

Income from continuing operations before accounting changes increased $149 million, or 67%, in the first six months of 2004, compared with the same period last year.   The growth resulted from a $312 million, or 10%, increase in railway operating revenues coupled with a 3% rise in railway operating expenses, which led to higher income from railway operations.

Railway Operating Revenues

Second-quarter railway operating revenues were $1.8 billion in 2004, up $180 million, or 11%, compared with the second quarter of 2003.   For the first six months, revenues were $3.5 billion, up $312 million, or 10%.   As shown in the following table, the increases were the result of higher traffic volume and increased average revenues.

Revenues, carloads and average revenue per unit for the commodity groups were as follows:

Coal

Coal revenues increased $35 million, or 9%, in the second quarter and $79 million, or 11%, in the first six months, compared with the same periods last year.   Total traffic volume (carloads) handled increased 2% in the quarter and 2% for the first six months, primarily because of higher export coal volume.   Export coal volume increased 49% in the quarter and 24% for the first six months, supported by increased demand for U.S. coal.   Reduced exports from China have resulted in more shipments to European steelmakers.   Shipments of utility coal declined 1% in the quarter, but increased 1% for the first six months.   Utility stockpiles remained low at some plants.   Increased demand from other markets and other factors could be drawing volume out of the utility market.   Domestic metallurgical coal, coke and iron ore volume declined 9% in the second quarter and 7% for the first six months, mostly because of reduced iron ore shipments.   Average revenue per carload was up 7% in the second quarter and 8% for the first six months, reflecting a favorable change in the mix of traffic (the rate of increase in longer haul traffic exceeded that of shorter haul traffic), higher rates for export coal and the favorable effects of a fuel surcharge.

In 2002, two of NS' utility customers, Duke Energy (Duke) and Carolina Power & Light (CP&L), filed rate reasonableness complaints at the STB alleging that NS' tariff rates for the transportation of coal were unreasonable.   In the Duke proceeding the STB initially found NS' rates to be reasonable in November 2003, but subsequently issued technical corrections in February 2004 finding that in certain years some portion of the rates was unreasonable.   The case is currently stayed while the STB considers both parties' petitions for reconsideration, and the STB has not yet ordered any rate relief.   In the CP&L proceeding the STB found NS' rates to be unreasonable in December 2003, but upheld a significant portion of NS' tariff increase.   Both of the STB's rate decisions remain subject to appeal.   NS is currently recognizing revenues based on the rates upheld or prescribed by the STB.   Future developments in the two cases may result in adjustments that could have a significant impact on results of operations in a particular quarter.   Over the long term, management believes the STB decisions in the Duke and CP&L proceedings will help support improved pricing for coal transportation services.

Coal revenues are expected to continue to show growth for the remainder of the year, supported by higher export and utility coal volumes and increased average revenue per shipment.

General Merchandise

General merchandise revenues increased $81 million, or 9%, in the second quarter and $130 million, or 7%, in the first six months, compared with the same periods last year.   Both increases reflected higher traffic volume, particularly for metals and construction and chemicals, and higher average revenues.   Metals and construction volume benefited from continued strength in construction activity and increased domestic steel production.   Chemicals traffic volume benefited from manufacturing expansion and higher plant operating rates.   Agriculture, consumer products and government volume reflected more shipments of corn, increased volume for fertilizer and more shipments for the military.   General merchandise average revenue per carload increased 4% in the second quarter and 3% for the first six months reflecting fuel surcharges, increased rates and longer lengths of haul.

General merchandise revenues are expected to continue to compare favorably with the prior year as 2004 progresses; however, the extent of the increase could lessen in the fourth quarter due to the strength of the fourth quarter of last year.

Intermodal

Intermodal revenues increased $64 million, or 21%, in the second quarter and $103 million, or 17%, in the first six months, compared with the same periods last year.   Traffic volume (units) increased 16% in the second quarter and 14% for the first six months reflecting very strong trailer and container volume.   Intermodal traffic volume continued to benefit from increased international and domestic truckload business as well as the conversion of truck traffic to rail.   Intermodal revenue per unit increased 4% for the quarter, and 3% for the first six months, as the favorable effects of rate increases and fuel surcharges were somewhat offset by an increase in lower-rated traffic.

Intermodal revenues are expected to continue to show growth during 2004, provided the retail and manufacturing sectors continue to expand.

Railway Operating Expenses

Second-quarter railway operating expenses were $1.4 billion in 2004, up $53 million, or 4%, compared with last year.   For the first six months, expenses were $2.7 billion, up $70 million, or 3%.   For both periods, most of the increase was the result of higher compensation and benefits and higher diesel fuel prices.

Compensation and benefits expenses increased $30 million, or 6%, in the second quarter and $49 million, or 5%, in the first six months, compared with the same periods last year.   Both periods reflected higher management and locomotive engineer incentive compensation (up $19 million for the quarter and $24 million for the first six months), higher wage rates (up $8 million for the quarter and $17 million for the first six months), and higher stock-based compensation (up $9 million for both periods) resulting from a rise in Norfolk Southern's stock price.   For both periods, higher volume-related train and engine payroll expenses were offset by reduced management employment levels.

Materials, services and rents increased $12 million, or 3%, in the second quarter and $17 million, or 2%, in the first six months, compared with the same periods last year.   For both periods, higher locomotive and freight car maintenance expenses and increased volume-related intermodal purchased services were partially offset by lower equipment rents.

Conrail rents and services expenses decreased $1 million, or 1%, in the second quarter and $6 million, or 3%, in the first six months, compared with the same periods last year.   The declines for both periods were primarily the result of lower expenses in the shared assets area.

Diesel fuel expenses increased $13 million, or 14%, in the second quarter and $16 million, or 8%, in the first six months, compared with the same periods last year, reflecting higher average prices and higher consumption.   The hedging program produced benefits of $26 million and $49 million in the second quarter and first six months of 2004, compared with benefits of $8 million and $34 million for the same periods of 2003, respectively.

Casualties and other claims expense decreased $9 million, or 19%, in the second quarter and $20 million, or 20%, in the first six months, compared with the same periods last year.   The decreases reflected the absence of unfavorable personal injury claims development, lower derailment-related expenses and lower insurance premiums.

Other expense increased $7 million, or 13%, in the second quarter, and $11 million, or 10%, in the first six months, compared with the same periods of last year.   The increases were largely the result of higher property taxes as last year benefited from a favorable property tax settlement.

Other Income - Net

Other income - net decreased $24 million in the second quarter and $35 million in the first six months of 2004, compared with the same periods of 2003.   Both comparisons reflected expenses related to new investments and lower investment returns on corporate-owned life insurance.

In June 2004, NS purchased a 40.5% membership interest in a limited liability company (LLC) that owns and operates facilities that produce synthetic fuel from coal.   The production of synthetic fuel results in tax credits as well as expenses related to the investments.   The expenses are recorded as a component of "Other income - net," and the tax credits, as well as tax benefits related to the expenses, are reflected in the provision for income taxes.

Provision for Income Taxes

The second-quarter effective income tax rate was 29.9% in 2004, compared with 31.2% last year.   For the first six months, the effective rate was 31.2% in 2004, compared with 31.5% in 2003.   Excluding NS' equity in Conrail's after-tax earnings, the second-quarter rate was 31.8% in 2004 and 33.9% in 2003, and the year-to-date rate was 33.2% in 2004, compared with 34.3% in 2003.   The declines for both periods were largely the result of the new synthetic fuel-related investments.

FINANCIAL CONDITION AND LIQUIDITY

Cash provided by operating activities, NS' principal source of liquidity, was $626 million in the first six months of 2004, compared with $366 million in the first six months of 2003.   The increase was primarily the result of the $242 million increase in income from railway operations.

A significant portion of payments made to PRR (which are included in "Conrail rents and services" and, therefore, are a use of cash in "Cash provided by operating activities") is borrowed back from a PRR subsidiary and, therefore, is a source of cash in "Proceeds from borrowings."   NS' net cash flow from these borrowings amounted to $81 million in the first six months of 2004 and $105 million for the same period of 2003.

NS' working capital deficit was $511 million at June 30, 2004 , compared with $376 million at Dec. 31, 2003 .   The increase reflected more current maturities of long-term debt.   A working capital deficit is not unusual for NS, and the company expects to generate sufficient cash flow from operations to meet its ongoing obligations.

NS currently has the capability to increase the amount of accounts receivable being sold under the revolving sale program to meet its more immediate working capital needs.   Over the last twelve months, the amount of receivables NS could sell under this program ranged from $359 million to $433 million, and the amount of receivables sold ranged from zero to $150 million.   Moreover, NS has a $1 billion credit facility that it can borrow under or use to support commercial paper debt; however, reductions in its credit rating could limit NS' ability to access the commercial paper markets.   The credit facility expires in 2006, and NS is in the process of negotiating its early renewal.

Cash used for investing activities was $443 million in the first six months of 2004, compared with $432 million in the first six months of 2003.   The increase was principally the result of more capital expenditures .

NS has made additional commitments to purchase locomotives and other equipment in the fourth quarter in the amount of approximately $160 million.   In addition, in July 2004, NS purchased an office building for approximately $30 million.   It is likely that NS will make all of its increased 2004 capital expenditures with internally generated funds.

Cash used for financing activities was $264 million in the first six months of 2004, compared with $8 million in the same period of 2003.   The change resulted from a significant debt maturity in February 2004, as $250 million of maturing debt was repaid with cash generated from operations.   Proceeds from borrowings consisted entirely of loans from the PRR subsidiary in both periods (see Note 2).   NS' debt-to-total capitalization ratio (excluding the notes payable to the PRR subsidiary) was 48.2% at June 30, 2004 , and 50.7% at Dec. 31, 2003 .   NS, when appropriate, may refinance a portion of its outstanding debt.

CONRAIL'S RESULTS OF OPERATIONS, FINANCIAL CONDITION AND LIQUIDITY

Conrail's second-quarter net income was $49 million in 2004, compared with $39 million in 2003.   For the first six months of 2004, Conrail's net income was $93 million, compared with $116 million for the same period of 2003.   Conrail's income before accounting changes was $94 million for the first six months of 2004, compared with $76 million for the same period of 2003.   The improvements were largely the result of higher operating and nonoperating income.

Conrail's working capital was $27 million at June 30, 2004 , compared with a deficit of $22 million at Dec. 31, 2003 .   Conrail is expected to have sufficient cash flow to meet its ongoing obligations.

OTHER MATTERS

Labor Agreements

Approximately 24,000 of NS' railroad employees are covered by collective bargaining agreements with several labor unions.   These agreements remain in effect until changed pursuant to the Railway Labor Act.   Moratorium provisions in these agreements permitted NS and the unions to propose such changes in late 1999; negotiations at the national level commenced shortly thereafter.

Agreements have been reached with the Brotherhood of Maintenance of Way Employes , which represents about 4,000 NS employees; the United Transportation Union , which represents about 7,000 NS employees; the International Brotherhood of Boilermakers and Blacksmiths, which represents about 100 NS employees; the Transportation Communications International Union, which represents about 4,000 NS employees; the American Train Dispatchers Association (ATDA), which represents about 350 NS employees; the Brotherhood of Railroad Signalmen, which represents about 1,000 NS employees; and the Brotherhood of Locomotive Engineers (BLE), which represents about 4,600 NS employees.   The agreements with the BLE and ATDA are through 2009; the other agreements are through 2004.  

The railroads and the International Brotherhood of Electrical Workers, which represents about 900 NS employees, have agreed to resolve their negotiations through arbitration.   Agreements have not yet been reached with the International Association of Machinists and Aerospace Workers, which represents about 1,000 NS employees; the Sheet Metal Workers International Association, which represents about 250 NS employees; the National Conference of Firemen and Oilers , which represents about 400 NS employees; and the International Longshoreman Association, which represents about 50 NS employees.  

Negotiations for the next round of national bargaining will commence with most rail labor unions on or shortly after Nov. 1, 2004 .

Market Risks and Hedging Activities

NS uses derivative financial instruments to reduce the risk of volatility in its diesel fuel costs and to manage its overall exposure to fluctuations in interest rates.

The intent of the diesel fuel hedging program is to assist in the management of NS' aggregate risk exposure to fuel price fluctuations, which can significantly affect NS' operating margins and profitability, through the use of one or more types of derivative instruments.   Diesel fuel costs represented 8% of NS' operating expenses for the second quarter of 2004.   The program provides that NS will not enter into any fuel hedges with a duration of more than 36 months, and that no more than 80% of NS' average monthly fuel consumption will be hedged for any month within any 36-month period.

However, with fuel prices near historic highs and fuel surcharges being collected under certain tariffs and contracts, NS is not currently entering into additional hedges at today's market levels.   Consequently, NS is modifying its fuel-hedging strategy on a go-forward basis, and the past pattern of entering into regular monthly swaps may not be indicative of future hedging activity.

As of June 30, 2004 , through swap transactions, NS has hedged approximately 69% of expected 2004 diesel fuel requirements, and 38% and 4% of expected requirements for 2005 and 2006, respectively.   The effect of the hedges is to yield an average cost of 83 cents per hedged gallon, including federal taxes and transportation.   A 10% decrease from current diesel fuel prices would reduce NS' asset related to the swaps by approximately $43 million as of June 30, 2004 .

NS manages its overall exposure to fluctuations in interest rates by issuing both fixed- and floating-rate debt instruments and by entering into interest-rate hedging transactions to achieve an appropriate mix within its debt portfolio.

At June 30, 2004 , NS' debt subject to interest rate fluctuations totaled $599 million (excluding debt due to the PRR subsidiary).   A 1% increase in interest rates would increase NS' total annual interest expense related to all its variable debt by approximately $6 million.   Management considers it unlikely that interest rate fluctuations applicable to these instruments will result in a material adverse effect on NS' financial position, results of operations or liquidity.

Some of NS' capital leases, which carry an average fixed rate of 7%, were effectively converted to variable rate obligations using interest rate swap agreements.   On June 30, 2004 , the average pay rate under these agreements was 2%, and the average receive rate was 7%.   The effect of the swaps was to reduce interest expense by $2 million in the second quarters of 2004 and 2003 and by $4 million for the first six months of 2004 and 2003, respectively.   A portion of the lease obligations is payable in Japanese yen.   NS eliminated the associated exchange rate risk at the inception of each lease with a yen deposit sufficient to fund the yen-denominated obligation.   Most of these deposits are held by foreign banks, primarily Japanese.   As a result, NS is exposed to financial market risk relative to Japan .   Counterparties to the interest rate swaps and Japanese banks holding yen deposits are major financial institutions believed by management to be creditworthy.

Environmental Matters

NS is subject to various jurisdictions' environmental laws and regulations.   It is NS' policy to record a liability where such liability or loss is probable and its amount can be estimated reasonably.   Claims, if any, against third parties for recovery of cleanup costs incurred by NS are reflected as receivables (when collection is probable) in the balance sheet and are not netted against the associated NS liability.   Environmental engineers regularly participate in ongoing   evaluations of all known sites and in determining any necessary adjustments to liability estimates.   NS also has established an Environmental Policy Council, composed of senior managers, to oversee and interpret its environmental policy.

NS' balance sheets included liabilities for environmental exposures in the amount of $23 million at June 30, 2004 , and $25 million at Dec. 31, 2003 (of which $8 million was accounted for as a current liability in each period).   At June 30, 2004 , the liability represented NS' estimate of the probable cleanup and remediation costs based on available information at 114 known locations.   On that date, 10 sites accounted for $12 million of the liability, and no individual site was considered to be material.   NS anticipates that much of this liability will be paid out over five years; however, some costs will be paid out over a longer period.

At some of the 114 locations, certain NS subsidiaries, usually in conjunction with a number of other parties, have been identified as potentially responsible parties by the Environmental Protection Agency (EPA) or similar state authorities under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, or comparable state statutes, which often impose joint and several liability for cleanup costs.

With respect to known environmental sites (whether identified by NS or by the EPA or comparable state authorities), estimates of NS' ultimate potential financial exposure for a given site or in the aggregate for all such sites are unavoidably imprecise because of the widely varying costs of currently available cleanup techniques, the likely development of new cleanup technologies, the difficulty of determining in advance the nature and full extent of contamination and each potential participant's share of any estimated loss (and that participant's ability to bear it), and evolving statutory and regulatory standards governing liability.

The risk of incurring environmental liability -- for acts and omissions, past, present and future -- is inherent in the railroad business.   Some of the commodities in NS' traffic mix, particularly those classified as hazardous materials, can pose special risks that NS and its subsidiaries work diligently to minimize.   In addition, several NS subsidiaries own, or have owned, land used as operating property, or which is leased or may have been leased and operated by others, or held for sale.   Because environmental problems that are latent or undisclosed may exist on these properties, there can be no assurance that NS will not incur environmental liabilities or costs with respect to one or more of them, the amount and materiality of which cannot be estimated reliably at this time.   Moreover, lawsuits and claims involving these and potentially other unidentified environmental sites and matters are likely to arise from time to time.   The resulting liabilities could have a significant effect on financial condition, results of operations or liquidity in a particular year or quarter.

However, based on its assessment of the facts and circumstances now known, management believes it has recorded the probably costs for dealing with those environmental matters of which the Corporation is aware.   Further, management believes that it is unlikely that any identified matters, either individually or in the aggregate, will have a material adverse effect on NS' financial position, results of operations or liquidity.

FORWARD-LOOKING STATEMENTS

This Management's Discussion and Analysis of Financial Condition and Results of Operations contains forward-looking statements that may be identified by the use of words like "believe," "expect," "anticipate" and "project."   Forward-looking statements reflect management's good-faith evaluation of information currently available.   However, such statements are dependent on and, therefore, can be influenced by, a number of external variables over which management has little or no control, including: domestic and international economic conditions; the business environment in industries that produce and consume rail freight; competition and consolidation within the transportation industry; fluctuation in prices of key materials, in particular diesel fuel; labor difficulties, including strikes and work stoppages; legislative and regulatory developments; changes in securities and capital markets; and natural events such as severe weather, floods and earthquakes.   Forward-looking statements are not, and should not be relied upon as, a guarantee of future performance or results.   Nor will they necessarily prove to be accurate indications of the times at or by which any such performance or results will be achieved. As a result, actual outcomes and results may differ materially from those expressed in forward-looking statements.   The Company undertakes no obligation to update or revise forward-looking statements.