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

OVERVIEW

Third-quarter 2008 net income was up $134 million, or 35%, compared with the same period last year.   The improvement primarily resulted from a $213 million increase in income from railway operations, reflecting higher average revenue per unit (including fuel surcharges) that continued to more than offset the effects of lower traffic volume and increased operating expenses.   The railway operating ratio (a measure of the amount of operating revenues consumed by operating expenses) decreased to 69.1% in the third quarter from 71.1% in the prior year.   

Cash provided by operating activities for the first nine months was $2.1 billion which provided funding for capital expenditures, dividends, and, supplemented with proceeds from borrowings, share repurchases.   In the third quarter of 2008, 6.2 million shares of Norfolk Southern Corporation common stock (Common Stock) were repurchased at a total cost of $405 million.  Since inception of the share repurchase program in 2006, NS has repurchased and retired 60.5 million shares of Common Stock at a total cost of $3.1 billion.   At Sept. 30, 2008, cash and short-term investment balances totaled $557 million.

SUMMARIZED RESULTS OF OPERATIONS

Third-quarter 2008 net income was $520 million, up $134 million, or 35%, compared with the same period last year.   The improvement primarily resulted from a $213 million increase in income from railway operations that reflected a $541 million, or 23%, rise in railway operating revenues coupled with a $328 million, or 20%, increase in railway operating expenses.   Third-quarter net income was reduced by an $83 million increase in income taxes, reflecting both higher pretax income and the absence of benefits associated with synthetic fuel tax credits that expired in 2007.

For the first nine months of 2008, net income was $1.3 billion, up $199 million, or 19%, compared with the same period last year.   Increases of $372 million in income from railway operations and $33 million in other income were offset in part by a $207 million increase in income taxes.   Railway operating revenues rose $1.2 billion, or 17%, while railway operating expenses were up $809 million, or 16%.

As a commodity, oil prices impact NS’ results of operations in a variety of ways and can have an overall favorable or unfavorable impact in any particular quarter.   In addition to the impact of oil prices on general economic conditions and traffic volume, oil prices directly affect NS’ revenues through market-based fuel surcharges and contract escalators (see “Railway Operating Revenues”) and expenses through fuel expense (see “Railway Operating Expenses”).   For the third quarter and first nine months, oil prices had an overall favorable impact on income from railway operations.   Future changes in oil prices may cause volatility in operating results that could be material to a particular quarter or year.

DETAILED RESULTS OF OPERATIONS

Railway Operating Revenues

Third-quarter 2008 railway operating revenues were $2.9 billion, up $541 million, or 23%, compared with the third quarter of 2007.   As shown in the following table, the increases were the result of higher average revenue per unit, including increased fuel surcharges, which were offset in part by lower traffic volume.   Fuel surcharges amounted to $535 million in the third quarter (up $339 million) and $1.3 billion for the first nine months (up $714 million).

Many of Norfolk Southern’s negotiated fuel surcharges for coal and general merchandise traffic are based on the monthly average price of West Texas Intermediate Crude Oil (WTI Average Price).   These surcharges are reset the first day of each calendar month based on the WTI Average Price for the second preceding calendar month.   This two-month lag in computing WTI Average Price increased fuel surcharge revenue by approximately $55 million for the third quarter, but decreased fuel surcharge revenue by approximately $39 million for the first nine months.    

Revenues, units and average revenue per unit for NS’ market groups were as follows:

Coal

Coal revenues increased $298 million, or 52%, in the third quarter and $599 million, or 35%, in the first nine months, compared with the same periods last year.   Both increases reflected higher rates, including fuel surcharges, increased traffic volume (up 6% for the quarter and 3% for the first nine months) and $22 million related to a coal customer’s 2008 contracted-volume shortfall and a nonrecurring effect related to the implementation of NS’ new coal billing system.   The higher rates were comprised of pricing increases and contract escalators and the effect of increased longer-haul export coal traffic.   For both periods, tonnage handled increased, reflecting improved export volume.   Coal tonnage by market was as follows:

Utility coal tonnage increased slightly in the third quarter but was essentially flat in the first nine months as higher export demand further tightened coal availability for domestic customers.   Export coal tonnage increased 55% for the third quarter and 60% for the first nine months, reflecting increased global demand coupled with weather-related supply constraints in Australia, reduced export volume from China and the continued weak dollar.   D omestic metallurgical coal, coke and iron ore tonnage increased 8% in the third quarter due to the start up of a new coke plant, coal sourcing changes and new business.   Industrial coal tonnage decreased 4% for the third quarter and 13% in the first nine months compared with 2007, principally due to coal supply constraints.

NS is currently involved in litigation with Virginia Electric and Power Company/Old Dominion Electric Cooperative (Virginia Power) regarding rate adjustment provisions in a transportation contract between them.   In 2007, the Virginia Supreme Court issued a decision that remanded the case to the trial court on the grounds that neither of its prior decisions constituted a final order.  On April 17, 2008, the trial court entered a final order granting NS monetary damages, including interest, and prescribing the methodology for determining future rates.   Virginia Power filed its Notice of Appeal on May 7, 2008.  Future developments and the ultimate resolution of this matter could result in NS recognizing additional revenues related to this dispute, which could have a favorable impact on results of operations in a particular year or quarter.

Coal revenues for the remainder of the year are expected to be up compared to prior year levels, due to higher average revenue per unit and continued strength in the domestic and metallurgical markets.

General Merchandise

General merchandise revenues increased $167 million, or 13%, in the third quarter and $429 million, or 11%, in the first nine months, compared with the same periods last year, a result of higher average revenue per unit.   The improvement in average revenue per unit reflected higher fuel surcharges and continued market-based pricing in all groups .   Traffic volume declined 6% for the quarter and 4% for the first nine months, driven primarily by lower automotive volumes.   Chemicals traffic volume decreased 5% for the third quarter and 4% for the first nine months, reflecting continued weakness in both plastics (linked to housing construction declines) and industrial intermediate products.   Metals and construction volume was up slightly in both periods as increased carloads from metals, principally scrap, offset declines in housing-related markets.   A griculture, consumer products and government volume increased 5% for both the third quarter and first nine months, reflecting increases in ethanol and military shipments.   Automotive volumes decreased 30% for the third quarter and 20% for the first nine months, reflecting reduced North American sales and production.  Automotive manufacturers, especially the domestic producers, continue to experience sales declines.  Ford, General Motors and Chrysler combined operate 16 of 26 assembly plants served by NS.  Four of these assembly plants implemented shift reductions during the first nine months of 2008, and two other plants have announced plans to reduce shifts in the fourth quarter.  In addition, one manufacturer has announced plans to close an assembly plant in the fourth quarter, and a second manufacturer has announced plans to idle an assembly plant as it retools to produce a new product in 2010.   NS continues to monitor the state of the automotive industry and the collectability of the associated receivables.   P aper, clay and forest traffic volume was down 6% for the third quarter and 7% for the first nine months, reflecting lower volumes related to the housing slowdown and continued decline in conventional paper markets.  

General merchandise revenues are expected to be higher for the remainder of the year compared with 2007 as improved pricing should continue to offset lower traffic volume.

Intermodal

Intermodal revenues increased $76 million, or 16%, in the third quarter and $153 million, or 11%, for the first nine months, compared with the same periods last year, primarily due to higher average revenue per unit including fuel surcharges.   Intermodal volume was flat in the third quarter, but declined 2% in the first nine months.   Domestic volume (which includes truckload and intermodal marketing companies’ [IMC] volumes) increased 18% for the third quarter and 6% for the first nine months, reflecting the relative efficiency of intermodal versus over-the-road transportation in a high fuel cost environment.   International traffic volume declined 9% for the third quarter and 7% for the first nine months, primarily driven by a soft economy and less inland rail movement of West Coast port traffic that offset East Coast port volume growth.   The Premium business, which includes parcel and less-than-truckload (LTL) carriers, decreased 2% for the third quarter and 3% for the first nine months, as reduced private empty movements and soft parcel business offset LTL conversions.   Triple Crown Services Company volume was down 5% for the third quarter and 1% for the first nine months primarily driven by reduced auto parts shipments.

Intermodal revenues for the remainder of the year are expected to continue to reflect growth due to increased revenue per unit and stronger domestic volumes related to truckload conversion to intermodal.

Railway Operating Expenses

Third-quarter railway operating expenses were $2.0 billion in 2008, up $328 million, or 20%, compared with the same period last year.   For the first nine months, railway operating expenses were $5.9 billion, up $809 million, or 16%, compared with the same period last year.

Compensation and benefits expenses increased $89 million, or 14%, in the third quarter and $146 million, or 8%, in the first nine months, compared with the same periods last year.   The changes reflected primarily the cost of lump-sum payments due under a new labor agreement with the Brotherhood of Locomotive Engineers and Trainmen (BLET) ($28 million), increased incentive compensation due to a higher projected payout (up $25 million for the quarter and $47 million for the first nine months), increased wage rates (up $18 million for the quarter and $38 million for the first nine months), and increased stock-based compensation primarily due to stock price increases during the periods (up $9 million for the quarter and $36 million for the first nine months).

Purchased services and rents increased $28 million, or 7%, in the third quarter and $39 million, or 3%, in the first nine months, compared with the same periods last year.   The increases were primarily driven by higher intermodal terminal costs, transportation operating costs and professional and legal services that were partially offset by lower equipment rents.

Fuel expense, which includes the cost of locomotive fuel as well as other fuel used in railway operations, increased $185 million, or 64%, for the third quarter and $553 million, or 68%, for the first nine months, compared with the same periods last year, reflecting sharply higher fuel prices.

Materials and other expenses (including the estimates of costs related to personal injury, property damage and environmental matters) increased $19 million, or 11%, in the third quarter and $51 million, or 8%, for the first nine months, compared with the same periods last year.   The increases reflected increased materials costs for locomotive and freight car repairs as well as higher expenses associated with derailments and employee travel and relocation costs.   The year-to-date increase also reflected costs associated with the Avondale Mills settlement related to the Graniteville accident (see additional discussion below) offset in part by favorable personal injury claims development.   The following table shows the components of materials and other expenses.

In April 2008, NS settled the lawsuit brought by Avondale Mills for claims associated with the Jan. 6, 2005, derailment in Graniteville, SC.  A portion of the settlement will not be reimbursed by insurance and was included in first-quarter 2008 expenses.  The total liability related to the derailment represents NS’ best estimate based on current facts and circumstances.   The estimate includes amounts related to business property damage and other economic losses, personal injury and individual property damage claims as well as third-party response costs.   NS’ commercial insurance policies are expected to cover substantially all expenses related to this derailment above the unreimbursed portion and NS’ self-insured retention, including NS’ response costs and legal fees.  The Consolidated Balance Sheets reflect current and long-term receivables for estimated recoveries from NS’ insurance carriers.   On July 1, 2008, NS filed a demand for arbitration against one of its insurance carriers that failed to respond to an insurance claim submitted by NS.  Although t he arbitral tribunal has been appointed, the carrier has not yet filed its grounds of defense.   However, it is likely that all or part of the recorded recovery attributable to such carrier ($100 million) will be contested.   NS believes these expenses are covered by the insurance policy and that recovery of any contested amount is probable, in that if the carrier contests payment an arbitrator would determine the settlement amounts to be reasonable and that the insurer’s refusal to consent to and to fund the settlement was a breach of contract.   In October 2008, another of NS’ insurance carriers provided the preliminary findings of its review of NS’ reimbursement request and reported that it may dispute a portion of that request.   NS believes that all expenses contained in the reimbursement request are covered by the insurance policy and that recovery is probable.

Other income – net

Other income – net increased $8 million in the third quarter and $33 million in the first nine months of 2008, compared with the same periods in 2007.   The increases reflect the absence of expenses related to synthetic fuel investments (down $18 million for the quarter and $64 million for the first nine months), reduced interest expense (down $11 million for the quarter and $21 million for the first nine months) due to second- and third-quarter adjustments to reflect the outcome of certain tax examinations and higher coal royalties (up $5 million for the quarter and $6 million for the first nine months).   These benefits were partially offset by fewer gains on the sale of property and investments (down $20 million for the quarter and $12 million for the first nine months), lower returns and higher borrowing costs on corporate-owned life insurance (down $8 million for the quarter and $40 million for the first nine months) and lower interest income (down $5 million for the quarter and $22 million for the first nine months).

Provision for Income Taxes

The third-quarter and year-to-date effective income tax rates were 36.7% and 37.8% in 2008, compared with 36.2% and 34.5% for the same periods last year.   The increases were largely due to the absence of synthetic fuel-related credits which expired at the end of 2007, offset by the tax benefit arising from the donation of a conservation easement as well as the absence of an Illinois tax law change which increased deferred taxes by $19 million in the third quarter of 2007.

The Internal Revenue Service completed its audit of NS’ consolidated federal income tax returns for 2004 and 2005 during the third quarter (see Note 2), and the 2006 and 2007 tax years are now being audited.

FINANCIAL CONDITION AND LIQUIDITY

Cash provided by operating activities, NS' principal source of liquidity, was $2.1 billion for the first nine months of 2008 and $1.8 billion for the first nine months of 2007.   NS had a working capital deficit of $221 million at Sept. 30, 2008, compared with a working capital deficit of $273 million at Dec. 31, 2007; the change was largely the result of increased proceeds from borrowings and cash flows from operations that were largely offset by higher debt repayments, property additions and share repurchases.   The payment of the Avondale Mills settlement affected working capital because the amount subject to arbitration is classified as a long-term receivable.   NS’ cash, cash equivalents and short-term investment balances totaled $557 million at Sept. 30, 2008.   NS expects that cash on hand combined with cash flows from operations will be sufficient to meet its ongoing obligations.   In addition to the contractual obligation amounts and information relating to NS’ future obligations related to certain tax positions contained in NS’ Form 10-K as of Dec. 31, 2007, NS (1) made additional purchase commitments for capital assets, discussed below, (2) through a private offering issued and sold $600 million in debt securities during the second quarter of 2008, and (3) decreased the unrecognized tax benefit by $33 million to $134 million primarily due to resolution of the 2004 and 2005 federal income tax audits.   The year of settlement of the $134 million unrecognized tax benefit cannot be reasonably estimated.

Cash used for investing activities was $810 million for the first nine months of 2008, compared with $600 million in the same period last year, reflecting higher property additions.   In the first quarter of 2008, Norfolk Southern’s Board of Directors approved the addition of $64 million to its 2008 capital budget to accelerate the purchase of approximately 750 new coal cars.   In July 2008, the Board of Directors authorized the addition of approximately $80 million to the 2008 capital budget, three quarters of which is to acquire new locomotives and the remainder to accelerate program track work.

Cash used for financing activities was $914 million for the first nine months of 2008, compared with $1.3 billion for the same period of 2007.   The change reflected net debt issuances of $99 million in 2008 compared with debt repayments of $454 million in 2007.   Additionally, NS share repurchases for the first nine months of 2008 were $130 million higher than for the first nine months of 2007.   The timing and volume of future share repurchases will be guided by management’s assessment of market conditions and other factors.   Near-term purchases under the share repurchase program are expected to be made with internally generated cash and proceeds from financings.   NS’ debt-to-total capitalization ratio was 39.2% at Sept. 30, 2008, compared with 39.6% at Dec. 31, 2007.

NS has in place and available a $1 billion, five-year credit agreement expiring in 2012, which provides for borrowings at prevailing rates and includes covenants.   NS had no amounts outstanding under this facility at Sept. 30, 2008, and NS is in compliance with all of the covenants.   Through February 2009, NS is ineligible to utilize its March 2001 and September 2004 Form S-3 registration statements due to a late filing of a Form 8-K which was unrelated to its financial condition or results of operations.   However, this is not expected to have an impact on financial liquidity.   Through a private offering, NS issued and sold $600 million in debt securities in April 2008 (see Note 7), and subsequently exchanged substantially all of these unregistered securities with essentially identical securities registered under the Securities Act of 1933.   In October 2008, NS renewed and amended its accounts receivable securitization facility, with a new 364-day term to run until October 2009.

APPLICATION OF CRITICAL ACCOUNTING ESTIMATES

The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.   These estimates and assumptions may require significant judgment about matters that are inherently uncertain, and future events are likely to occur that may require management to change them.   Accordingly, management regularly reviews these estimates and assumptions based on historical experience, changes in the business environment and other factors that management believes to be reasonable under the circumstances.   Management regularly discusses the development, selection and disclosures concerning critical accounting estimates with the Audit Committee of its Board of Directors.   There have been no significant changes to the Application of Critical Accounting Estimates disclosure contained in NS’ Form 10‑K as of Dec. 31, 2007.

OTHER MATTERS

Labor Agreements

Approximately 26,000, or about 85%, of NS' railroad employees are covered by collective bargaining agreements with various labor unions.   These agreements remain in effect until changed pursuant to the Railway Labor Act (RLA).   NS largely bargains in concert with other major railroads.   Moratorium provisions in the labor agreements govern when the railroads and the unions may propose changes.

NS recently reached an agreement with the BLET that extends its contract through 2014.   The new BLET agreement covers approximately 5,000 engineers and provides each the opportunity for an annual bonus payment based on company financial and service performance metrics and his or her work availability in the previous year.   In addition, in October 2008, members of the International Association of Machinists and Aerospace Workers (IAM) ratified an agreement with NS.

The most recent bargaining round began in late 2004.   Since that time, the railroads have reached agreements that extend through 2009 with all of the rail unions.   Because NS has reached separate agreements with the BLET and the American Train Dispatchers Association (ATDA), only the health and welfare provisions from the national agreements apply to NS’ locomotive engineers and ATDA-represented dispatchers.  

Market Risks and Hedging Activities

NS uses derivative financial instruments to manage its overall exposure to fluctuations in interest rates.   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 Sept. 30, 2008, NS' debt subject to interest rate fluctuations totaled $122 million.   A 1% increase in interest rates would increase NS' total annual interest expense related to all its variable debt by approximately $1 million.   Management considers it unlikely that interest rate fluctuations applicable to these instruments will result in a material adverse effect on NS' financial condition, 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 Sept. 30, 2008, the average pay rate under these agreements was 3%, and the average receive rate was 7%.   The effect of the swaps was to reduce interest expense by less than $1 million in the third quarter and first nine months of both 2008 and 2007.   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 Consolidated Balance Sheets 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 an Environmental Policy Council, composed of senior managers, to oversee and interpret its environmental policy.

NS' Consolidated Balance Sheets include liabilities for environmental exposures in the amount of $39 million at Sept. 30, 2008, and $46 million at Dec. 31, 2007 (of which $12 million is classified as a current liability at the end of each period).   At Sept. 30, 2008, the liability represents NS' estimate of the probable cleanup and remediation costs based on available information at 148 known locations.   As of that date, 11 sites account for $19 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 30 locations, one or more subsidiaries of NS, 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 necessarily 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.

Based on an assessment of known facts and circumstances, management believes that it is unlikely that any known matters, either individually or in the aggregate, will have a material adverse effect on NS' financial condition, results of operations or liquidity.

New Accounting Pronouncement

In September 2006, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157, “Fair Value Measurements.”   This statement, effective for interim or annual reporting periods beginning after Nov. 15, 2007, establishes a framework for measuring fair value in U.S. generally accepted accounting principles and expands disclosures about fair value measurements.   NS adopted the statement Jan. 1, 2008, related to financial instrument assets and liabilities with no material effect on NS’ consolidated financial statements.

Inflation

In preparing financial statements, U.S. generally accepted accounting principles require the use of historical cost that disregards the effects of inflation on the replacement cost of property.   NS, a capital-intensive company, has most of its capital invested in such assets.   The replacement cost of these assets, as well as the related depreciation expense, would be substantially greater than the amounts reported on the basis of historical cost.

FORWARD-LOOKING STATEMENTS

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; interest rates; the business environment in industries that produce and consume rail freight; competition and consolidation within the transportation industry; fluctuation in prices or availability of key materials, in particular diesel fuel; labor difficulties, including strikes and work stoppages; legislative and regulatory developments; results of litigation; changes in securities and capital markets; disruptions to our technology infrastructure, including our computer systems; and natural events such as severe weather, hurricanes and floods.   For a discussion of significant risk factors applicable to NS, see Part I, Item 1A “Risk Factors” in NS’ Form 10-K as of Dec. 31, 2007, and any updates contained herein.   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.   NS undertakes no obligation to update or revise forward-looking statements.