UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

 

Commission file number 1-5046

 

CNF INC.

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code: (650) 378-5200

 

Securities Registered Pursuant to Section 12(b) of the Act:

 

 

Securities Registered Pursuant to Section 12(g) of the Act:

87/8% Notes Due 2010

(Title of class)

 

6.70% Senior Debentures due 2034

(Title of class)

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yesþ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.
Large accelerated filer þ     Accelerated filer o     Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

Aggregate market value of voting stock held by persons other than Directors, Officers and those shareholders holding more than 5% of the outstanding voting stock, based upon the closing price per share on June 30, 2005: $1,691,279,820

 

Number of shares of Common Stock outstanding as of January 31, 2006: 52,215,570

 

DOCUMENTS INCORPORATED BY REFERENCE

Part III

 

Proxy Statement for CNF’s Annual Meeting of Shareholders to be held on April 18, 2006 (only those portions referenced specifically herein are incorporated in this Form 10-K).

 

 

CNF INC.
FORM 10-K
Year Ended December 31, 2005

 

 

INDEX

 

CNF INC.
FORM 10-K
Year Ended December 31, 2005

 

Legal Organization

 

CNF Inc. was incorporated in Delaware in 1958, and in 2001, changed its name from CNF Transportation Inc. to CNF Inc. CNF Inc. and its subsidiaries (“CNF” or “the Company”) provide transportation and supply chain management services for a wide range of manufacturing, industrial, and retail customers.

 

At December 31, 2005, CNF owned 100% of the capital stock of Con-Way Transportation Services, Inc., Con-Way Supply Chain Services, LLC, Menlo Worldwide, LLC, and other less significant wholly owned subsidiaries. Con-Way Supply Chain Services, LLC wholly owned Con-Way NOW, Inc., Con-Way Truckload Services, LLC, and Con-Way Global Solutions, Inc. (also known as Con-Way Air Express). At December 31, 2005, Menlo Worldwide, LLC (“MW”) wholly owned Menlo Logistics, Inc. (also known as Menlo Worldwide Logistics or “MWL”) and owned a majority interest in the Vector SCM joint venture with General Motors. In December 2004, CNF completed the sale of Menlo Worldwide Forwarding, Inc. and its subsidiaries and Menlo Worldwide Expedite!, Inc. (previously wholly owned subsidiaries of MW and hereinafter collectively referred to as “MWF”) to United Parcel Service, Inc. (“UPS”), as more fully discussed in Note 2, “Discontinued Operations,” of Item 8, “Financial Statements and Supplementary Data.”

 

In January 2006, CNF announced a proposal to change its name from “CNF Inc.” to “Con-way Inc.” The proposed corporate name change marks the launch of an integrated strategy to bring the Company’s operations under a single master brand and value identity. If shareholders approve the name change at the Annual Meeting of Shareholders on April 18, 2006, the first stage will be a phased “re-branding” of the operations of Con-Way Transportation Services, Inc. and its subsidiaries under a single graphic identity and a new Con-Way logo. Later phases of the re-branding initiative will involve the Company’s Menlo Worldwide Logistics subsidiary. Company management and the Board of Directors believe that the corporate name change and the re-branding initiative will create a single brand for accurate market identity, clarity and customer understanding, thereby enabling the Company to compete more effectively in the markets it serves.

 

Reporting Segments

 

Information on reporting segments is presented in the manner in which components are organized for making operating decisions, assessing performance, and allocating resources, which may be different than the manner in which components are organized for legal purposes, as described above. Accordingly, for financial reporting purposes, CNF is divided into three segments.

 

Con-Way Transportation Services reporting segment (“Con-Way”).  Includes the combined operating results of Con-Way Transportation Services, Inc. and its subsidiaries and affiliated supply chain services companies. Con-Way provides regional next-day, second-day, and transcontinental freight trucking throughout the U.S., Canada, Puerto Rico, and Mexico, as well as expedited transportation, freight forwarding, and truckload brokerage services.

 

Menlo Worldwide reporting segment.  Includes the operating results of Menlo Worldwide Logistics (“Logistics”) and Vector SCM, LLC (“Vector”), a company jointly owned by MW and General Motors (“GM”). Logistics develops contract logistics solutions, including the management of complex distribution networks and supply chain engineering and consulting. Vector serves as the lead logistics manager for GM and provides logistics services to other customers to a lesser degree.

 

CNF Other reporting segment.  Includes the operating results of Road Systems, Inc., a trailer manufacturer, and certain corporate activities.

For financial information concerning CNF’s geographic and reporting segment operating results, refer to Item 8, “Financial Statements and Supplementary Data,” under Note 12, “Segment Reporting.”

 

Information Available on Website

 

CNF makes available, free of charge, on its website at “www.cnf.com,” under the headings “Investor Relations/Annual Report, Proxy and Other SEC Filings,” copies of its annual reports on Form 10-K, quarterly reports on Form 10-Q, and current reports on Form 8-K, and any amendments to those reports, in each case as soon as reasonably practicable after such reports are electronically filed with or furnished to the Securities and Exchange Commission.

 

In addition, CNF makes available, free of charge, on its website at “www.cnf.com,” under the headings “Investor Relations/Corporate Governance,” current copies of the following documents: (i) the charters of the Audit, Compensation, and Director Affairs Committees of its Board of Directors; (ii) its Corporate Governance Guidelines; (iii) its Code of Ethics for Chief Executive and Senior Financial Officers; (iv) its Code of Business Conduct and Ethics for Directors; and (v) its Code of Ethics for employees. Copies of these documents are also available in print to shareholders upon request, addressed to the Corporate Secretary at 2855 Campus Drive, Suite, 300, San Mateo, California 94403.

 

None of the information on CNF’s website shall be deemed to be a part of this report.

 

Regulatory Certifications

 

In 2005, CNF filed the written affirmations and Chief Executive Officer certifications required by Section 303A.12(a) of the New York Stock Exchange “NYSE” Listing Manual, Rule 503(k)(5)(D) and Rule 5.3(m) of the Pacific Exchange Listing Manual and Section 302 of the Sarbanes-Oxley Act.

 

Con-Way Transportation Services

 

Con-Way Regional Carriers

 

Con-Way’s primary business units are regional less-than-truckload (“LTL”) motor carriers that operate a combined network of freight service centers to provide market coverage in North America. The regional carriers provide industry-leading day-definite delivery service to manufacturing, industrial, and retail customers, and consist of Con-Way Western Express (“CWX”), which serves 13 Western states, including Hawaii and Alaska; Con-Way Central Express (“CCX”), which serves 25 central and eastern states; Con-Way Southern Express (“CSE”), which serves 12 southeastern states, the District of Columbia and Puerto Rico; Con-Way Canada Express, which serves 10 Canadian provinces; and Con-Way Mexico, which began operations in July 2005 to facilitate the movement of cross-border freight as well as between points in Mexico. In 2005, the regional carriers accounted for 95.3% of Con-Way’s revenue.

 

Typically, LTL carriers transport shipments weighing between 100 and 15,000 pounds from multiple shippers utilizing a network of freight service centers combined with a fleet of linehaul and pickup-and-delivery tractors and trailers. Freight is picked up from customers and consolidated for shipment at the originating service center. The freight is then loaded into trailers and transferred to the destination service center providing service to the delivery area. From the destination service center, the freight is delivered to the customer.

 

Con-Way Supply Chain Services Group

 

In addition to the regional LTL carriers, Con-Way operates a supply chain services group of businesses, which includes Con-Way NOW, Con-Way Air Express, and Con-Way Truckload (“CTL”). CTL began operations in January 2005.

 

Con-Way NOW specializes in time-definite shipments, such as replacement parts, medical equipment, and other urgent shipments, where expedited delivery is critical, with delivery service in 48 states and parts of Canada. Con-Way NOW also operates a truckload brokerage operation under the name of Con-Way Full Load. Con-Way Air Express (“CAX”) is a freight forwarder that arranges freight shipments using transportation provided by other

operators, including commercial airlines, dedicated air operators, for-hire truckload and LTL operators, and cartage companies. Through an agency network and connections with other Con-Way companies, CAX provides full-service coverage in the U.S., Canada, and Puerto Rico. CTL serves Con-Way’s three regional LTL carriers by providing linehaul service on full loads of LTL shipments moving in transcontinental lanes and also offers the services to other customers. The formation of CTL was intended to reduce linehaul expense and protect service with inter-company operations that operate in tandem with current truckload vendors. CTL utilizes Con-Way’s existing infrastructure and administrative support services to minimize the required investment. In the fourth quarter of 2005, CTL began operating in regional truckload lanes to complement the transcontinental offering. As the truckload business grows, Con-Way expects to more than double the size of the CTL tractor fleet in 2006 as part of CNF’s capital expenditure plan.

 

Competition

 

The trucking, truck brokerage, and freight forwarding industry segments are intensely competitive. Principal competitors of Con-Way include regional and national LTL companies. Competition in the trucking industry segment is based on freight rates, service, reliability, transit times and scope of operations.

 

Menlo Worldwide

 

Effective January 1, 2002, CNF formed Menlo Worldwide by combining its Logistics and Vector SCM units with its Forwarding segment, which was sold in December 2004. The formation of Menlo Worldwide was intended to address a trend among businesses to outsource the management of increasingly complex supply chain and logistics services to lower costs, reduce inventories and increase speed, flexibility and efficiency. The MW companies were aligned to meet this demand by combining extensive proprietary information systems and value-added supply chain management services including transportation, warehouse, and inventory management on a global scale.

 

Menlo Worldwide — Logistics

 

Since the formation of Logistics in 1990, the third-party logistics segment has grown significantly as the outsourcing of distribution and other non-core functions has become more commonplace and businesses increasingly evaluate overall logistics costs. The ability to access information through computer networks also increases the value of capturing real-time logistics information to track inventories, shipments, and deliveries.

 

Logistics specializes in developing and managing complex national and global supply and distribution networks, including primarily transportation management and contract warehousing. Transportation management refers to the management of asset-based carriers and third-party transportation providers for customers’ inbound/outbound supply chain needs through the use of state-of-the-art logistics management systems to consolidate, book and track shipments. Contract warehousing refers to the optimization of warehouse operations for customers using technology and warehouse management systems to reduce inventory carrying costs and supply chain cycle times. For several customers, contract-warehousing operations include light assembly or kitting operations. Logistics’ ability to link these systems with its customers’ internal enterprise resource planning systems is intended to provide customers with improved visibility to their supply chains. Compensation from Logistics’ customers takes different forms, including cost-plus, gain-sharing, transaction, fixed-dollar, and consulting fees.

 

Historically, Logistics has provided these services using a customer- or project-based approach, which included customer-specific transportation management, single-client warehouses, and single-customer technological solutions. As the market place drives efficiency, Logistics is transitioning to a shared-resource, process-based approach to leverage a centralized transportation management group, utilize more multi-client warehouses, and create technological solutions that benefit multiple customers. This approach is expected to leverage Logistics’ resources to provide scaleable supply chain and logistics services to a growing number of middle-market customers. Logistics started the transition to a shared-resource, process-based approach in 2005, when it segmented its business based on customer type. The new industry-focused groups leverage the capabilities of personnel, systems and solutions throughout the organization to give customers expertise in their specific automotive, high-tech, and consumer products sectors.

Logistics’ client base doubled to approximately 200 customers at December 31, 2005 from December 31, 2004, due primarily to the integration of Con-Way Logistics, as described below. Although Logistics’ client base includes a growing number of middle-market companies, Logistics’ primary customers are Fortune 200 businesses. Four customers collectively accounted for 50.5% of the revenue reported for the Logistics reporting segment in 2005, and each had a Standard & Poor’s investment-grade credit rating. In 2005, Logistics’ largest customer accounted for 4.9% of the consolidated revenue of CNF. The loss of significant revenue from any of Logistics’ major customers by termination of the customer relationship for any reason, including the business failure of the customer, could have an adverse effect on Logistics’ results of operations.

 

Con-Way Logistics Integration

 

In the second quarter of 2005, Logistics integrated into its operations the Con-Way Logistics business, which was previously reported in the Con-Way reporting segment. The integration of the two businesses is intended to provide an enterprise solution offering for Logistics’ customers that want to use Con-Way as a primary transportation provider in addition to those customers that want a vendor-neutral transportation solution. The integration also expands Con-Way Logistics’ multi-client warehousing service model to Logistics’ larger warehouse network.

 

Competition

 

The third-party logistics segment is intensely competitive. Competition for larger projects is generally based on the ability to rapidly implement technology-based transportation and logistics solutions, while competition for projects with middle-market customers is more influenced by price. Competitors in the logistics segment are numerous and include domestic and foreign logistics companies, the logistics arms of integrated transportation companies, and contract manufacturers. However, Logistics primarily competes against a limited number of major competitors that have resources sufficient to provide services under large logistics contracts.

 

Menlo Worldwide — Vector

 

In December 2000, CNF and GM formed the Vector SCM (supply chain management) joint venture for the purpose of providing logistics management services on a global basis for GM, and for customers in addition to GM. Although MW owns a majority interest in Vector, MW’s portion of Vector’s operating results are reported in the Menlo Worldwide reporting segment as an equity-method investment based on GM’s ability to control certain operating decisions. Vector was established to reduce GM’s supply chain costs and improve GM’s supply chain management by bringing increased speed, visibility, flexibility, and reliability to GM’s global supply chain, including shipment of parts to manufacturing plants and vehicles to dealers.

 

Prior to the amendments described below, agreements pertaining to Vector (collectively, “Vector Agreements”) provided that Vector would be compensated by sharing in efficiency gains and cost savings achieved through the implementation of Approved Business Cases (“ABCs”) and other special projects in GM’s North America region and three international regions. An ABC is a project, developed with and approved by GM, aimed at reducing costs, assuming operational responsibilities, and/or achievement of operational changes.

 

In August 2003, the Vector Agreements were amended, primarily to expedite the transition of logistics services in the North America region from GM to Vector. The amendments changed the compensation principles for GM’s North American logistics operations, revised the allocation of Vector’s profit between GM and MW, and modified the formula for the valuation of Vector in the event that MW exercises its Put Right. Effective January 1, 2005, for the 2005 calendar year, all of the ABCs for GM’s European region were amended to compensate Vector with cost reimbursement and a management fee based on vehicle production volumes, rather than through separately approved ABCs. Refer to Item 7, “Management’s Discussion and Analysis,” under “Results of Operations — Menlo Worldwide — Vector.” Also refer to Note 3, “Investment in Unconsolidated Joint Venture,” in Item 8, “Financial Statements and Supplementary Data.”

 

CNF Other

 

The CNF Other reporting segment includes the operating results of Road Systems, Inc. and certain corporate activities. A majority of the revenue from Road Systems is from sales to other CNF subsidiaries.

Discontinued Operations

 

Menlo Worldwide Forwarding

 

On December 19, 2004, CNF completed the sale of MWF to UPS, as more fully discussed in Note 2, “Discontinued Operations,” of Item 8, “Financial Statements and Supplementary Data.”

 

Priority Mail Contract

 

On November 3, 2000, Emery Worldwide Airlines, Inc. (“EWA”), a subsidiary of CNF, 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”). Claims relating to amounts owed to EWA under the Priority Mail contract were settled in connection with payments from the USPS to EWA in 2002 and 2001. Refer to Note 2, “Discontinued Operations,” of Item 8, “Financial Statements and Supplementary Data,” and Note 11, “Commitments and Contingencies.”

 

Spin-Off of CFC

 

On December 2, 1996, CNF completed the spin-off of Consolidated Freightways Corporation (“CFC”) to CNF’s shareholders. Refer to Note 11, “Commitments and Contingencies,” in Item 8, “Financial Statements and Supplementary Data.”

 

General

 

Employees

 

At December 31, 2005, CNF had approximately 21,800 regular full-time employees. The approximate number of regular full-time employees by segment was as follows: Con-Way, 18,000; Menlo Worldwide Logistics, 2,700; CNF Other, 1,100. The 1,100 employees included in the CNF Other segment consist primarily of technology, executive, and administrative positions that support CNF’s operating subsidiaries.

 

Cyclicality and Seasonality

 

CNF’s operating results are affected, in large part, by conditions in the cyclical markets of its customers and on the U.S. and global economies. Demand for transportation services fluctuates in response to overall economic conditions. Any sustained weakness in demand or continued downturn or uncertainty in the economy generally would have an adverse effect on CNF’s businesses.

 

CNF’s operating results are also affected by seasonal fluctuations that affect demand for transportation services. In the trucking industry for a typical year, the months of September, October, and November usually have the highest business levels while the months of December, January and February usually have the lowest business levels.

 

Price and Availability of Fuel

 

As more fully discussed in Item 1A, “Risk Factors,” CNF is exposed to the effects of changes in the availability and price of diesel fuel.

 

Regulation

 

Ground Transportation

 

The motor carrier industry is subject to federal regulation by the Federal Motor Carrier Safety Administration (“FMCSA”), the Pipeline and Hazardous Materials Safety Agency (“PHMSA”), and the Surface Transportation Board (“STB”), which are units of the U.S. Department of Transportation (“DOT”). The FMCSA promulgates and enforces comprehensive trucking safety regulations and performs certain functions relating to such matters as motor carrier registration, cargo and liability insurance, extension of credit to motor carrier customers, and leasing of

equipment by motor carriers from owner-operators. The PHMSA promulgates and enforces regulations regarding the transportation of hazardous materials. The STB has authority to resolve certain types of pricing disputes and authorize certain types of intercarrier agreements.

 

At the state level, federal preemption of economic regulation does not prevent the states from regulating motor vehicle safety on their highways. In addition, federal law allows all states to impose insurance requirements on motor carriers conducting business within their borders, and empowers most states to require motor carriers conducting interstate operations through their territory to make annual filings verifying that they hold appropriate registrations from FMCSA. Motor carriers also must pay state fuel taxes and vehicle registration fees, which normally are apportioned on the basis of mileage operated in each state.

 

In April of 2003, the FMCSA issued a final rule to change the regulations governing hours of service (“HOS”) for commercial truck drivers. The rule increased the total consecutive off-duty hours a driver must take prior to driving in interstate commerce and reduced the total daily consecutive driving and on-duty hours allowed. In July of 2004, the United States Court of Appeals for the District of Columbia voided the HOS rules that were issued by the FMCSA. However, the United States Congress extended the existing HOS rules until September 2005. In October of 2005, a final rule issued by FMCSA became effective. The new rule changed the way that drivers utilizing sleeper berths may split their off-duty time, raising concern that the efficiency of sleeper-team truckload operations similar to those utilized by Con-Way Truckload may be adversely affected.

 

The same advocacy groups that challenged the 2003 FMCSA HOS rules may mount another challenge to the rules which became effective in October 2005. Given the uncertainty in the status of the HOS rules, CNF cannot predict whether the current rules will remain intact or whether the rules as finally adopted will materially affect its operations.

 

Environmental

 

CNF is subject to laws and regulations that (i) govern activities or operations that may have adverse environmental effects such as discharges to air and water, as well as handling and disposal practices for solid and hazardous waste, and (ii) impose liability for the costs of cleaning up, and certain damages resulting from sites of past spills, disposals, or other releases of hazardous materials. Environmental liabilities relating to CNF’s properties may be imposed regardless of whether CNF leases or owns the properties in question and regardless of whether such environmental conditions were created by CNF or by a prior owner or tenant, and also may be imposed with respect to properties that CNF may have owned or leased in the past. CNF has provided for its estimate of remediation costs at these sites.

 

CNF’s operations involve the storage, handling, and use of diesel fuel and other hazardous substances. In particular, CNF is subject to environmental laws and regulations dealing with fuel storage tanks and the transportation of hazardous materials laws.

 

CNF has been designated a Potentially Responsible Party by the EPA with respect to the disposal of hazardous substances at various sites. CNF expects that its share of the clean-up costs will not have a material adverse effect on CNF’s financial condition, cash flows, or results of operations.

 

Homeland Security

 

CNF is subject to compliance with cargo security and transportation regulations issued by the Transportation Security Administration (“TSA”) and by the Department of Homeland Security (“DHS”), including regulation by the Bureau of Customs and Border Protection (“CBP”). CNF believes that it will be able to comply with potential TSA, DHS, and CBP rules, which will require additional security measures impacting the transportation of both domestic and international shipments.

 

Con-Way’s regional carriers, as well as certain other subsidiaries, are approved by the CBP to participate in the voluntary Customs-Trade Partnership Against Terrorism program (“C-TPAT”). The C-TPAT program was designed in 2002 to provide a process to facilitate the efficient release of goods and provide resolution of any outstanding issues affecting CBP processing of cross-border shipments. As participants of C-TPAT, these subsidiaries have

developed security measures that continue to evolve along with the C-TPAT program requirements. These subsidiary C-TPAT security plans have been reviewed and certified by the CBP.

 

C-TPAT does not provide a sector category for third-party logistics companies; as a result, Logistics cannot obtain C-TPAT certification. To address this issue, Logistics has voluntarily adopted C-TPAT “Importer” requirements into its security plan, which incorporates regulatory DHS requirements, and also voluntarily participates in non-regulatory DHS programs that secure customer and international supply chains against terrorism and theft.

 

Con-Way Air Express has been approved by TSA as an Independent Air Carrier (“IAC”), and has developed security measures that have been reviewed and certified by the TSA. Logistics became a certified IAC and incorporated TSA security regulatory requirements into its IAC security plan.

 

Business Interruption

 

CNF and its subsidiaries rely on CNF’s Administrative and Technology (“Adtech”) Center, a centralized shared-service facility in Portland, Oregon, for the performance of shared administrative and technology services in the conduct of their businesses. CNF’s computer facilities and its administrative and technology employees are located at the AdTech Center. Although CNF maintains backup systems and has disaster recovery processes and procedures in place, a sustained interruption in the operation of these facilities, whether due to terrorist activities, earthquakes, floods or otherwise, could have a material adverse effect on CNF’s financial condition, results of operations, and cash flows.

 

Customer Concentration

 

Menlo Worldwide and many of its competitors in the third-party logistics segments are subject to risk related to customer concentration because of the relative importance of their largest customers and the increased ability of those customers to influence pricing and other contract terms. Although Menlo Worldwide continues to broaden and diversify its customer base, a significant portion of its revenue and operating results are derived from a relatively small number of customers, as more fully discussed in Item 1, “Business.” Consequently, a significant loss of business from, or adverse performance by, any of Menlo Worldwide’s major customers, particularly GM, may have a material adverse effect on CNF’s financial condition, results of operations, and cash flows. Similarly, the renegotiation of Menlo Worldwide’s major customer contracts may also have an adverse effect on CNF.

 

Cyclicality

 

CNF’s operating results are affected, in large part, by conditions in the cyclical markets of its customers and on the U.S. and global economies. Demand for transportation services fluctuates in response to overall economic conditions. Any sustained weakness in demand or continued downturn or uncertainty in the economy generally would have an adverse effect on CNF’s businesses.

 

Employees

 

The workforce of CNF and its subsidiaries is not affiliated with labor unions. CNF believes that the non-unionized operations of its subsidiaries have advantages over comparable unionized competitors in providing reliable and cost-competitive customer services, including greater efficiency and flexibility. There can be no assurance that CNF’s subsidiaries will be able to maintain their non-unionized status.

 

CNF hires drivers primarily for its Con-Way business segment. There is significant competition for qualified drivers in the transportation industry. As a result of driver shortages, Con-Way may be required to increase driver compensation, utilize lower-quality drivers or face difficulty meeting customer demands, all of which could adversely affect CNF’s results of operations.

 

Employee Benefit Costs

 

CNF maintains health and welfare plans and a defined benefit pension plan, and provides certain other benefits to its employees. In recent years, health care costs have risen dramatically, and lower interest rates and returns on

plan assets have increased the expense of, and funding requirements for, CNF’s defined benefit pension plan. In addition, the U.S. Congress is considering legislation that may affect the ongoing cost and funding of the defined benefit pension plan. As a result, CNF is unable to predict the effect of continuing to provide these benefits to employees on CNF’s financial condition, results of operations, and cash flows.

 

Government Regulation

 

CNF is subject to compliance with many laws and regulations that apply to its business activities. These include regulations relating to hours of service for its drivers, and cargo security and transportation regulations issued by the Department of Homeland Security and the Department of Transportation. CNF is not able to accurately predict how new governmental laws and regulations, or changes to existing laws and regulations, will affect the transportation industry generally, or CNF in particular. Although government regulation that affects CNF and its competitors may simply result in higher costs that can be passed on to customers with no adverse consequences, there can be no assurance that this will be the case. As a result, CNF believes that any additional security and other measures that may be required by future laws and regulations or changes to existing laws and regulations could result in additional costs and could have an adverse effect on its ability to serve customers and on its financial condition, results of operations, and cash flows.

 

Price and Availability of Fuel

 

CNF is exposed to the effects of changes in the availability and price of diesel fuel. Generally, fuel can be obtained from various sources and in the desired quantities. However, an inability to obtain fuel due to fuel shortages or any other reason could have a material adverse effect on CNF. CNF and its subsidiaries (primarily Con-Way) are subject to the risk of price fluctuations. Like other LTL carriers, Con-Way assesses many of its customers with a fuel surcharge. The fuel surcharge is a part of Con-Way’s overall rate structure for customers and is intended to compensate Con-Way for the adverse effects of higher fuel costs. As fuel prices have risen, the fuel surcharge has increased Con-Way’s yields and revenue, and Con-Way has more than recovered higher fuel costs and fuel-related increases in purchased transportation. At times, in the interest of its customers, Con-Way has temporarily capped the fuel surcharge at a fixed percentage. Following a sharp increase in fuel costs in the aftermath of hurricanes in the U.S., Con-Way imposed a temporary cap on its fuel surcharge in 2005 that was in effect from August 29 through October 24. CNF cannot predict the future movement of fuel prices, Con-Way’s ability to recover higher fuel costs through fuel surcharges, or the effect that changes in fuel surcharges may have on Con-Way’s overall rate structure. Con-Way’s operating income would likely be adversely affected by a rapid and significant decline in fuel prices as lower fuel surcharges would reduce Con-Way’s yield and revenue. Whether fuel prices increase, decrease, or remain constant, Con-Way’s operating income may be adversely affected if competitive pressures limited Con-Way’s ability to assess its fuel surcharges.

 

None.

 

CNF believes that its facilities are suitable and adequate, that they are being appropriately utilized, and that they have sufficient capacity to meet current operational needs. Management continuously reviews anticipated requirements for facilities and may acquire additional facilities and/or dispose of existing facilities as appropriate. Due largely to growth in tonnage, CNF anticipates capital expenditures of approximately $395 million (including software expenditures) in 2006. The capital expenditures consist primarily of $127 million related to land and buildings, including approximately $27 million for improvements, and $141 million for the acquisition of additional tractor and trailer equipment for Con-Way’s regional carriers. Con-Way’s truckload business expects to add $67 million of additional tractor and trailer equipment.

 

Con-Way Transportation Services

 

As of December 31, 2005, Con-Way’s regional carriers operated 343 freight service centers, of which 150 were owned and 193 were leased. The service centers, which are strategically located to cover the geographic areas served by Con-Way, represent physical buildings and real property with dock, office, and/or shop space. These

facilities do not include meet-and-turn points, which generally represent small owned or leased real property with no physical structures. The total number of trucks, tractors, and trailers utilized by the Con-Way regional carriers at December 31, 2005 was approximately 30,900.

 

At December 31, 2005, Con-Way Air Express operated 13 leased warehouse and service center facilities.

 

At December 31, 2005, Con-Way Truckload operated approximately 531 tractors and trailers.

 

Menlo Worldwide Logistics

 

As of December 31, 2005, Logistics operated 55 warehouses in North America, of which 38 were leased by Logistics and 17 were leased or owned by clients of Logistics. Internationally, Logistics operated an additional 25 warehouses, of which 20 were leased by Logistics and 5 were leased or owned by clients.

 

At December 31, 2005, Logistics operated approximately 68 trucks, tractors, and trailers.

 

CNF Other

 

Principal properties of the CNF Other segment included CNF’s leased executive offices in San Mateo, California, and its owned Administrative and Technology Center in Portland, Oregon. Road Systems’ owned manufacturing facility is in Searcy, Arkansas.

 

Certain legal proceedings of CNF are also discussed in Item 1, “Business,” under “Regulation — Environmental,” and in Note 2, “Discontinued Operations,” and Note 11, “Commitments and Contingencies,” of Item 8, “Financial Statements and Supplementary Data.”

 

In 2002, EWA, MWF, Inc., MW and CNF Inc. were named as defendants in a lawsuit filed in state court in California by approximately 140 former EWA pilots and crew members. The lawsuit alleges wrongful termination in connection with the termination of EWA’s air carrier operations, and seeks $500 million and certain other unspecified damages. CNF believes that the lawsuit’s claims are without merit, and is vigorously defending the lawsuit.

 

In 2003, prior to the sale of MWF to UPS, CNF became aware of information that Emery Transnational, a Philippines-based joint venture in which MWF, Inc. may be deemed to be a controlling partner, may have made certain payments in violation of the Foreign Corrupt Practices Act. CNF promptly notified the Department of Justice and the Securities and Exchange Commission of this matter, and MWF, Inc. instituted policies and procedures in the Philippines designed to prevent such payments from being made in the future. CNF was subsequently advised by the Department of Justice that it is not pursuing an investigation of this matter. CNF conducted an internal investigation of approximately 40 other MWF, Inc. international locations and has shared the results of the internal investigation with the SEC. The internal investigation revealed that Menlo Worldwide Forwarding (Thailand) Limited, a Thailand-based joint venture, also may have made certain payments in violation of the Foreign Corrupt Practices Act. MWF, Inc. made certain personnel changes and instituted policies and procedures in Thailand designed to prevent such payments from being made in the future. In December 2004, CNF completed the sale of its air freight forwarding business (including the stock of MWF, Inc., Emery Transnational and Menlo Worldwide Forwarding (Thailand) Limited) to an affiliate of UPS. In connection with that sale, CNF agreed to indemnify UPS for certain losses resulting from violations of the Foreign Corrupt Practices Act. CNF is currently unable to predict whether it will be required to make payments under the indemnity.

 

CNF did not submit any matter to a vote of security holders during the fourth quarter of the fiscal year covered by this Annual Report.

 

The Executive Officers of CNF, their ages at December 31, 2005, and their applicable business experience are as follows:

 

Douglas W. Stotlar, 45, President and Chief Executive Officer of CNF. Mr. Stotlar was named to his current position in April 2005. He previously served as President and Chief Executive Officer of Con-Way Transportation Services and Senior Vice President of CNF, a position he held since December 2004. Prior to this, he served as Executive Vice President and Chief Operating Officer of Con-Way, a position he held since June 2002. From 1999 to 2002, he was Executive Vice President of Operations for Con-Way. Prior to joining Con-Way’s corporate office, Mr. Stotlar served as Vice President and General Manager of Con-Way NOW. Mr. Stotlar joined the Con-Way organization in 1985 as a Freight Operations Supervisor for Con-Way Central Express. He subsequently advanced to management posts in Columbus, Ohio, and Fort Wayne, Indiana, where he was named Regional Manager. Mr. Stotlar earned his bachelor’s degree in transportation and logistics from Ohio State University.

 

Kevin C. Schick, 54, Senior Vice President and Chief Financial Officer of CNF. Mr. Schick was named to his current position in March 2005. He previously served as Vice President and Controller of Con-Way Transportation Services, a position he held since 1989. Mr. Schick joined the Con-Way organization in 1983 as Controller for Con-Way Central Express. Mr. Schick earned his bachelor’s degree in Finance from Marquette University and a master’s degree in business administration from Northwestern University.

 

Jennifer W. Pileggi, 41, Senior Vice President, General Counsel and Corporate Secretary of CNF. Ms. Pileggi was named to her current position in December 2004. Ms. Pileggi joined CNF’s subsidiary Menlo Logistics in 1996 as Corporate Counsel and was promoted to Vice President in 1999. She was promoted to Vice President and Corporate Counsel of Menlo Worldwide in 2003. Ms. Pileggi is a graduate of Yale University and New York University School of Law, where she achieved a juris doctorate degree. Ms. Pileggi is a member of the American Bar Association and the California State Bar Association.

 

David S. McClimon, 50, President of Con-Way Transportation Services, Inc. and Senior Vice President of CNF. Mr. McClimon was named to his current position in June 2005. He previously served as President and Chief Executive Officer of two of Con-Way’s regional trucking companies: Con-Way Central Express from 2002 to 2005, and Con-Way Western Express from 2000 to 2002. He was Vice President of Sales for Con-Way Central Express from 1997 to 2000. Prior to this, he was Vice President of National Sales for Con-Way Transportation Services from 1993 to 1997. Mr. McClimon joined the Con-Way organization in 1983 as a day-one employee of Con-Way Central Express and subsequently was promoted to a variety of sales and operations positions. Mr. McClimon earned his bachelor’s degree in marketing from Miami University in Ohio.

 

John G. Labrie, 39, President of Con-Way Supply Chain Solutions and Vice President of CNF. Mr. Labrie was named to his current position in June 2005. He previously served as Executive Vice President of Operations for Con-Way Transportation Services, a position he held since January 2005. Prior to this, he served as President and Chief Executive Officer for Con-Way Western Express, a position he held since June 2002. From May 1998 to June 2002, he was Vice President of Operations for Con-Way Western Express. He joined the Con-Way organization in 1990 as a sales account manager. Mr. Labrie earned his bachelor’s degree in Finance from Central Michigan University. He holds a master’s degree in business administration from Indiana Wesleyan University.

 

Robert L. Bianco Jr., 41, President of Menlo Worldwide and Vice President of CNF. Mr. Bianco was named to his current position in June 2005. He previously served as President of Menlo Logistics, a position he held since December 2001. He joined the CNF organization in 1989 as a management trainee and joined Menlo in 1992 as a logistics manager. He subsequently advanced to Vice President of Operations for Menlo Logistics in 1997. He is a graduate of the University of California at Santa Barbara and earned a master’s degree from the University of San Francisco.

 

Jackie Barretta, 44, Vice President and Chief Information Officer of CNF. Ms. Barretta was named to her current position in February 2005. She previously served as Vice President of Information Services for Con-Way Transportation Services, a position she held since August 2000. Prior to this, she served as Director of Information Services, a position she held since 1997. She joined Con-Way as a systems analyst in 1996. Ms. Barretta earned her bachelor’s degree in Computer Science from the University of North Carolina.

Mark C. Thickpenny, 53, Vice President and Treasurer of CNF. Mr. Thickpenny joined CNF in 1995 as Treasury Manager. In 1997, he was named Director and Assistant Treasurer, and in 2000 was promoted to Vice President and Treasurer. Mr. Thickpenny holds a bachelor’s degree in business administration from the University of Notre Dame and a master’s degree in business administration from the University of Chicago Graduate School of Business.

 

Kevin S. Coel, 47, Vice President and Corporate Controller of CNF. Mr. Coel joined CNF in 1990 as CNF’s Corporate Accounting Manager. In 2000, he was named Corporate Controller, and in 2002, was promoted to Vice President. Mr. Coel holds a bachelor’s degree in economics from the University of California at Davis and a master’s degree in business administration from San Jose State University. Mr. Coel is also a member of the American Institute of CPAs.

 

CNF’s common stock is listed for trading on the New York Stock Exchange (“NYSE”) under the symbol “CNF.”

 

See Item 8, “Financial Statements and Supplementary Data” under Note 13, “Quarterly Financial Data,” for the range of common stock prices as reported on the NYSE and common stock dividends paid for each of the quarters in 2005 and 2004. At January 31, 2006, CNF had 7,196 common shareholders of record.

 

The following table provides a summary of share repurchases made by CNF during the quarter ended December 31, 2005:

 

 

 

[1] In January 2005, CNF’s Board of Directors authorized a two-year stock repurchase program providing for the repurchase of up to $300 million in common stock in open market purchases and privately negotiated transactions.

 

CNF Inc.
Five-Year Financial Summary

 

 

CNF’s results from continuing operations included various income or loss items that affected the comparability of the reported operating income (loss) of its reporting segments. Other materially significant items affecting the comparability of net income from continuing operations in the years reported above are described in the notes below and in Item 7, “Management’s Discussion and Analysis.”

 

 

 

 

 

Introduction

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations (referred to as “Management’s Discussion and Analysis”) is intended to assist in a historical and prospective understanding of CNF’s results of operations, financial condition, and cash flows, including a discussion and analysis of the following:

 

 

Overview of Business

 

CNF provides transportation, logistics, and supply chain management services for a wide range of manufacturing, industrial, and retail customers. For financial reporting purposes, CNF is divided into three reporting segments: Con-Way Transportation Services (“Con-Way”), primarily a provider of regional less-than-truckload (“LTL”) freight services; Menlo Worldwide, a provider of contract logistics solutions; and CNF Other, which includes certain corporate activities and Road Systems, a trailer manufacturer. Menlo Worldwide consists of the operating results of Menlo Worldwide Logistics (“Logistics”) and Vector SCM, a joint venture with GM that is accounted for as an equity-method investment.

 

CNF’s operating results are generally expected to depend on the number and weight of shipments transported, the prices received on those shipments, and the mix of services provided to customers, as well as the fixed and variable costs incurred by CNF in providing the services and the ability to manage those costs under changing shipment levels. Con-Way primarily transports shipments through a freight service center network while Logistics and Vector manage the logistics functions of their customers and primarily utilize third-party transportation providers for the movement of customer shipments.

 

As more fully discussed under “Results of Operations — Discontinued Operations,” CNF and Menlo Worldwide, LLC (“MW”) in 2004 sold MWF to UPS. Accordingly, the results of operations, net liabilities, and cash flows of the Forwarding segment have been segregated and reported as discontinued operations, except where otherwise noted.

Results of Operations

 

The table below summarizes CNF’s consolidated operating results.

 

 

 

 

CNF’s net income from continuing operations (after preferred stock dividends) grew 55.8% to $221.5 million ($3.96 per diluted share) in 2005 from $142.2 million ($2.57 per diluted share) in 2004 due to improved operating results from all CNF reporting segments. In 2005, CNF’s net income available to common shareholders of $215.3 million ($3.85 per diluted share) improved significantly over a net loss in the prior year, due primarily to last year’s $276.3 million loss from the disposition of MWF. As more fully discussed below under “Results of Operations — Discontinued Operations,” in the periods presented, discontinued operations related to the sale of MWF, the shut-down of EWA and its terminated Priority Mail contract with the USPS, and the spin-off of CFC.

 

CNF’s net income from continuing operations (after preferred stock dividends) in 2004 rose 26.7% to $142.2 million ($2.57 per diluted share). Net income from continuing operations was offset by a $266.3 million net loss ($4.72 per diluted share) from discontinued operations, which primarily reflects the loss from the disposition of MWF. The resulting net loss applicable to common shareholders in 2004 was $124.1 million ($2.15 per diluted share).

Continuing Operations

 

 

Overview — 2005 Compared to 2004

 

In 2005, CNF’s revenue increased 12.3% to $4.2 billion, due to higher revenue at all reporting segments. Consolidated operating income in 2005 rose 30.5% on significantly higher operating income from Con-Way and improved results from Menlo Worldwide. Con-Way’s operating income increased 34.0% due largely to revenue growth of 11.2% and improved regional-carrier operating margins. Con-Way’s revenue increase in 2005 reflects regional-carrier tonnage growth and yield improvement on increased fuel surcharges while higher operating income reflects improved margins. Improved operating margins at Con-Way primarily reflect revenue growth, productivity gains, and a decline in employee costs as a percentage of revenue, due largely to lower incentive compensation that resulted from variations in operating income and other performance factors relative to incentive plan targets. Menlo Worldwide’s operating income in 2005 increased 14.5% on improved results at Logistics and higher income from Vector’s foreign operations. Logistics’ operating income increased 17.4% on revenue growth of 14.0% and reported segment income from Vector increased 11.0% to $20.3 million.

 

Other net expense in 2005 decreased $17.7 million to $19.6 million, due primarily to increases in investment income, which rose $15.2 million on increased average cash equivalents and marketable securities. Increased investment income also reflects higher interest rates earned by cash equivalents and marketable securities in 2005. Interest expense decreased $2.2 million in 2005 due largely to the net effect on interest from financing transactions, including the $100.0 million repayment in June 2005 of the 7.35% Notes, the $128.9 million redemption in June 2004 of 5% Convertible Debentures, and the $292.6 million net issuance in April 2004 of 6.7% Senior Debentures. Other net miscellaneous non-operating expenses in 2005 primarily reflects $2.7 million of costs in 2004 associated with the redemption of the Convertible Debentures, partially off set by a $2.5 million increase in foreign exchange losses in 2005.

 

CNF’s effective tax rate of 34.7% declined from 39.0% in 2004. The lower rate in 2005 reflects reversals of accrued income taxes of $7.8 million, which related to an IRS settlement of issues related to tax years prior to 2002. Excluding the effect of the reversals of accrued taxes, the lower effective tax rate in 2005 was due primarily to an increase in tax-exempt interest income, increased foreign tax credits, and the effect of the GAAP classification of income on Vector’s increasing foreign income. As more fully discussed in Note 3, “Investment in Unconsolidated

Joint Venture,” of Item 8, “Financial Statements and Supplementary Data,” MW’s portion of U.S. federal income taxes on Vector’s domestic income is reported in CNF’s tax provision. CNF’s foreign tax credits related to Vector’s foreign income are also reflected in CNF’s tax provision. However, under GAAP, MW’s portion of Vector’s foreign income taxes on its foreign income is reported as a component of equity-method income and is not a component of CNF’s tax provision.

 

Overview — 2004 Compared to 2003

 

In 2004, CNF’s revenue increased 15.0% to $3.7 billion, due to higher revenue at all reporting segments, which benefited from improved economic conditions. Consolidated operating income in 2004 rose 26.3%, on significantly higher operating income from Con-Way and improved operating results from Menlo Worldwide. The increase in Con-Way’s operating income was due principally to the effect of improved margins on revenue growth, as Con-Way’s operating income in 2004 increased 30.7% on revenue growth of 17.0%. Menlo Worldwide’s operating income increased 7.3% on improvement from Logistics, partially offset by a decline in operating income from Vector. Logistics reported a 30.0% increase in operating income on a 10.5% growth in revenue while Vector’s operating income in 2004 fell $2.5 million to $18.3 million.

 

In 2004, other net expense increased $9.9 million to $37.3 million, due primarily to increases in interest expense and other net non-operating expenses, partially offset by higher interest income on marketable securities. Interest expense in 2004 rose $10.1 million due largely to the net effect of financing transactions in 2004, as described above. Other net miscellaneous non-operating expenses in 2004 reflects a $4.3 million decline in the income from corporate-owned life insurance policies that were terminated in the third quarter of 2004, $2.7 million of costs associated with the redemption of the Convertible Debentures, and a $1.3 million decline in foreign exchange gain, partially offset by prior-year equity venture losses of $3.7 million.

 

Con-Way Transportation Services

 

The table below compares operating results (dollars in thousands), operating margins, and the percentage increase in selected operating statistics of the Con-Way reporting segment for the years ended December 31.

 

 

 

In 2005, Con-Way’s revenue rose 11.2% due to higher revenue from Con-Way’s regional carriers and continued growth from the Con-Way supply chain services group, which includes Con-Way NOW, Con-Way Air Express, and Con-Way Truckload. Revenue per day from the regional carriers rose 12.4% from 2004 on a 7.9% increase in weight and a 4.2% increase in yield. Yield increases in 2005 primarily reflect an increase in fuel surcharges, continued growth in higher-rated interregional services, and general rate increases, partially offset by growth in lower-yielding lower-cost shipments, as more fully discussed below. Like other LTL carriers, Con-Way assesses many of its customers with a fuel surcharge. The fuel surcharge is part of Con-Way’s overall rate structure for customers and is intended to compensate Con-Way for the adverse effects of higher fuel costs. As fuel prices have risen, the fuel surcharge has increased Con-Way’s yield and revenue. At times, in the interest of its customers, Con-Way has temporarily capped the fuel surcharge at a fixed percentage. Following a sharp increase in fuel costs in the aftermath of hurricanes in the U.S., Con-Way imposed a temporary cap on its fuel surcharge in 2005 that was in

effect from August 29 through October 24. Excluding fuel surcharges, yields in 2005 were unchanged compared to 2004. Yields in 2005 were adversely affected by a 3.6% increase in weight per shipment, which was largely driven by a spot-quote program that contributed to an increase in the number of shipments in excess of 10,000 pounds. The spot-quote program was developed to place lower-yielding large shipments into empty linehaul leg segments without requiring additional capacity. Commensurate with the lower transportation cost per unit of weight, spot-quote and other lower-cost higher-weight shipments generally have lower yields.

 

Con-Way’s operating income in 2005 increased 34.0%, due largely to improved margins, which primarily reflect revenue growth, productivity gains, and a decline in employee costs as a percentage of revenue. In 2005, fuel and purchased transportation costs increased 64.2% and 19.3%, respectively. However, higher fuel costs and fuel-related increases in purchased transportation costs were more than recovered through fuel surcharges, as discussed above and more fully discussed in Item 1A, “Risk Factors — Price and Availability of Fuel.” Employee costs in 2005 increased 5.0%, but declined as a percentage of revenue. Employee costs in 2005 reflect increases in base compensation and employee benefits, partially offset by lower incentive compensation. Base compensation rose 9.5%, due primarily to headcount increases attributable to higher business volumes, and to a lesser extent, wage and salary rate increases. Incentive compensation in 2005 declined by $27.7 million or 34.7% based on variations in operating income and other performance factors relative to incentive plan targets. Employee benefits expense increased 2.6%, as an increase in health and welfare costs, due largely to growth in headcount, was partially offset by a decline in workers’ compensation expense. Lower workers’ compensation expense in 2005 was largely due to improved claims experience and a third-quarter entry in 2004 to correct the cumulative under-recognition of expense on certain prior-period claims, which had a $3.9 million adverse effect, net of incentive compensation.

 

In 2004, Con-Way’s revenue rose 17.0% due to higher revenue from Con-Way’s regional carriers and continued growth from Con-Way’s supply chain services group of businesses. Revenue per day from the regional carriers rose 16.0% from 2003 on increases in weight and yield. In 2004, management believes that growth in weight transported was due primarily to comparatively better economic conditions and market share gains. Yield improvement in 2004 was achieved primarily through higher fuel surcharges and general rate increases, partially offset by growth in lower-yielding business from the spot-quote program. Excluding fuel surcharges, yield in 2004 rose 0.3%. Con-Way’s operating income in 2004 increased 30.7% on improved margins from the regional carriers as well as improved results from Con-Way’s supply chain services, which reduced their collective net operating loss in 2004 by $5.5 million from 2003. Certain corporate expenses previously allocated to the discontinued Forwarding segment are reported in continuing operations, as more fully discussed in Note 2 “Discontinued Operations,” of Item 8, “Financial Statements and Supplementary Data.” The additional corporate overhead charge allocated to the Con-Way reporting segment was $14.8 million in 2004 and $12.2 million in 2003.

 

Menlo Worldwide

 

The Menlo Worldwide reporting segment consists of the operating results of Logistics and Vector. Menlo Worldwide in 2005 reported operating income of $46.9 million, an increase of 14.5% over last year. Although MW owns a majority equity interest, the operating results of Vector are reported as an equity-method investment based on GM’s ability to control certain operating decisions. Accordingly, CNF’s Consolidated Statements of Operations do not include any revenue from Vector and only MW’s proportionate share of the net income from Vector is reported as a reduction of operating expenses.

 

The table below compares operating results (dollars in thousands) and operating margins of the Menlo Worldwide reporting segment for the years ended December 31. The table summarizes Logistics net revenues (revenues less transportation expenses) as well as gross revenues. Logistics’ management believes that net revenues

are a meaningful measure of the relative importance of its principal services since total revenues earned on most carrier-management services include the third-party carriers’ charges to Logistics for carrying the shipments.

 

 

Menlo Worldwide — Logistics

 

Logistics’ revenue in 2005 increased 14.0% over 2004, due to increases in carrier-management and warehouse-management services. In 2005, revenue from carrier-management services increased 15.9%, while revenue from warehouse-management services rose 7.6%. Carrier-management revenue is attributable to contracts for which Logistics manages the transportation of freight but subcontracts the actual transportation and delivery of products to third parties, which Logistics refers to as purchased transportation. Logistics’ net revenue (revenue less purchased transportation) in 2005 increased 6.5%.

 

In 2005, Logistics’ operating income increased 17.4% due primarily to revenue growth and improved margins on warehouse-management services, partially offset by a decline in margins on carrier-management services. Margins on warehouse-management and carrier-management services were positively affected by lower employee costs, which were due primarily to declines in health and welfare costs, workers’ compensation, and incentive compensation. Incentive compensation in 2005 declined by $1.0 million or 13.7% based on variations in operating income and other performance measures relative to incentive plan targets. In 2005, margins on carrier-management services were adversely affected by higher purchased transportation costs. In 2005, purchased transportation costs grew 17.2% due to increased business levels and fuel-related increases in carrier rates. Management will seek to improve carrier-management margins by evaluating customer contracts and renegotiating certain lower-margin contracts. Management is intending to increase the number of customers being served by Logistics’ centralized transportation-management group, which is expected to increase operating margins by reducing administrative costs.

 

Beginning in the second quarter of 2005, Logistics integrated into its operations the Con-Way Logistics business, which was previously reported in the Con-Way reporting segment. Accordingly, the operating results of Con-Way Logistics are reported with Menlo Worldwide Logistics and prior periods have been reclassified to conform to the current-period presentation. The integration of the two businesses is intended to provide an enterprise solution offering for Logistics’ customers that want to use Con-Way as a primary transportation provider in addition to those customers who want a vendor-neutral transportation solution. The integration also expands Con-Way Logistics’ multi-client warehousing service model to Logistics’ larger warehouse network.

 

In 2004, Logistics’ revenue rose 10.5% over 2003, due principally to an increase in carrier-management and warehouse-management services. Operating income in 2004 improved 30.0% to $22.7 million, due primarily to revenue growth. Significantly higher revenue at the former Con-Way Logistics operations contributed to a $4.3 million reduction in the operating loss related to those operations. Operating margins in 2004 were adversely affected by the competitive transportation pricing environment, the renegotiation of certain contracts with existing customers, a decrease in margins during the start-up phase of new contracts, and to higher employee costs. Operating income in 2003 was adversely affected by $3.1 million of contract termination costs. Certain corporate expenses previously allocated to the discontinued Forwarding segment are reported in continuing operations, as more fully discussed in Note 2, “Discontinued Operations,” of Item 8, “Financial Statements and Supplementary

Data.” The additional corporate overhead charge allocated to the Logistics reporting segment was $2.1 million in 2004 and $1.8 million in 2003.

 

Menlo Worldwide — Vector

 

Operating Results

 

In 2005, segment income reported from MW’s equity investment in Vector increased to $20.3 million from $18.3 million in 2004. Higher reported segment income from Vector was due primarily to higher income earned in GM’s international regions, partially offset by a decline in income from GM’s North America region. Improved income in GM’s international regions was substantially due to a $9.7 million increase in volume-based compensation, which resulted from increased business levels and the revised compensation rates in GM’s European region, as described below. Higher income from the international regions was partially offset by lower income from GM’s North America region, which reflects a $1.7 million reduction in volume-based compensation and a $6.8 million decline in performance-based compensation, as defined below. Income reported from MW’s equity investment in Vector declined to $18.3 million in 2004 from $20.7 million in 2003 as a $9.0 million decline in volume-based income from North America was partially offset by increases in performance-based income of $4.4 million and $2.5 million in the North America and international regions, respectively.

 

North America

 

In August 2003, the Vector Agreements were amended, primarily to expedite the transition of logistics services in the North America region from GM to Vector. Prior to the 2003 amendment, agreements pertaining to Vector provided that Vector would be compensated by sharing in efficiency gains and cost savings achieved through the implementation of Approved Business Cases (“ABCs”) and other special projects in GM’s North America region and GM’s three international regions. An ABC is a project, developed with and approved by GM, aimed at reducing costs, assuming operational responsibilities, and/or achieving operational changes.

 

Under the amended Vector Agreements, Vector is compensated for its management of logistics for all of GM’s North America operations rather than through its sharing in efficiency gains and cost savings under individual ABCs. In each year of a five-year period from January 1, 2003, Vector will be compensated with a management fee based on shipment volumes (“volume-based compensation”) and, beginning in 2004, can earn additional compensation if certain performance criteria are achieved (“performance-based compensation”). In accordance with GAAP, compensation under the volume-based management fee is recognized as vehicles are shipped while performance-based compensation is recognized on the achievement of specified levels of cost savings, which will generally not be determinable until the fourth quarter of each contract year. Vector will also be compensated by GM for its direct and administrative costs in North America, subject to certain limitations. For other special projects in GM’s North America region, Vector is compensated under ABCs. CNF expects a declining amount of compensation from the management fee in each successive year covered under the amended Vector agreements for North America. Except for special projects compensated under ABCs, Vector’s North America region did not earn performance-based compensation in 2005, based primarily on current-year increases in fuel and other transportation costs that prevented the attainment of performance criteria in 2005. CNF believes that similar external market conditions will also prevent the attainment of performance criteria in 2006.

 

International

 

Compensation earned from GM’s European region in 2005 increased $7.7 million due primarily to increased business levels and an amendment to the ABCs for GM’s European region. Effective January 1, 2005, for the 2005 calendar year, all of the ABCs for GM’s European region were amended to compensate Vector with cost reimbursement and a management fee based on vehicle production volumes, rather than through the separately approved ABCs. An agreement has been reached with GM to transition the management of defined logistics activities to Vector under a similar cost reimbursement and volume-based management fee structure for 2006 and 2007. The compensation principles for GM’s Latin America and Asia/Pacific regions are unaffected by the amendments in the European region.

Call Right and Put Right

 

Under the Vector Agreements, GM has the right to purchase MW’s membership interest in Vector (“Call Right”) and MW has the right to require GM to purchase MW’s membership interest in Vector (“Put Right”). The Call Right and Put Right are exercisable at the sole discretion of GM and MW, respectively. Under the amended Vector Agreements, the amount payable by GM to MW under the Put Right is based on a mutually agreed-upon estimated value for MW’s membership interest as of the contract amendment date and will decline on a straight-line basis over an 8-year period beginning January 1, 2004. Exercise of MW’s Put Right or GM’s Call Right would result in MW retaining any commercialization contracts involving customers other than GM.

 

CNF Other

 

The CNF Other segment consists of the results of Road Systems and certain corporate activities. A majority of the revenue from Road Systems was from sales to Con-Way. The CNF Other segment reported operating losses of $3.1 million in 2005 and $4.0 million in 2004. The net loss in 2005 primarily reflects a $2.2 million loss resulting from an insurance settlement, while 2004 was affected by corporate insurance activities and sales of corporate properties. The $2.4 million operating loss in 2003 primarily includes a net loss from the sale of corporate properties.

 

Discontinued Operations

 

Discontinued operations in the periods presented relate to the sale of MWF, to the shut-down of EWA and its terminated Priority Mail contract with the USPS, and to the spin-off of CFC. The results of operations, net liabilities, and cash flows of discontinued operations have been segregated from continuing operations, except where otherwise noted. The operating results and net liabilities of discontinued operations are summarized in Note 2, “Discontinued Operations,” of Item 8, “Financial Statements and Supplementary Data.”

 

MWF

 

Impairment Charge

 

On October 5, 2004, CNF and MW entered into a stock purchase agreement with UPS to sell all of the issued and outstanding capital stock of MWF. CNF completed the sale on December 19, 2004, as more fully discussed below. Although the stock purchase agreement was entered into on October 5, 2004, decisions by CNF’s management and its Board of Directors and the third-quarter sale negotiations with UPS established CNF’s commitment to sell MWF as of September 30, 2004. In the process of evaluating several strategic alternatives for Menlo Worldwide’s Forwarding segment, CNF was approached by UPS in the third quarter of 2004 with interest in acquiring MWF. Accordingly, in the third quarter of 2004, CNF classified MWF as held for sale and recognized a $260.5 million impairment charge to write down the recorded book value of MWF to its anticipated selling price, less costs to sell. The impairment charge was based on the agreement to sell MWF, as described below, and primarily represents the estimated write-down to the fair value of MWF’s goodwill and long-lived assets, including MWF’s accumulated foreign currency translation adjustment, as well as estimated selling costs.

 

Stock Purchase Agreement

 

The stock purchase agreement excludes certain assets and liabilities of MWF and includes certain assets and liabilities of CNF or its subsidiaries related to the business conducted by MWF. Among the assets and liabilities so excluded are those related to EWA, and the obligation related to MWF employees covered under CNF’s domestic pension, postretirement medical and long-term disability plans. Under the agreement, UPS agreed to pay to CNF an amount equal to MWF’s cash position as of December 31, 2004, and to pay the estimated present value of CNF’s retained obligations related to MWF employees covered under CNF’s long-term disability and postretirement medical plans, as agreed to by the parties. Under the stock purchase agreement, CNF has agreed to a three-year non-compete covenant that, subject to certain exceptions, will limit CNF’s annual air freight and ocean forwarding and/or customs brokerage revenues to $175 million through CNF’s 2007 fiscal year. CNF has also agreed to indemnify UPS against certain losses that UPS may incur after the closing of the sale with certain limitations. Any losses related to these indemnification obligations or any other costs, including any future cash expenditures, related

to the sale that have not been estimated and recognized at this time will be recognized in future periods as an additional loss from disposal when and if incurred. For additional details, refer to the stock purchase agreement filed as an exhibit to CNF’s Form 8-K dated October 5, 2004 and the amendment to the stock purchase agreement filed as an exhibit to CNF’s Form 8-K dated December 21, 2004.

 

Disposition of MWF

 

Upon completion of the sale of MWF on December 19, 2004, CNF received cash consideration of $150 million, subject to certain post-closing adjustments, including adjustments for cash held by MWF at closing and MWF’s net working capital as of closing. In connection with the sale, CNF in 2004 recognized a fourth-quarter loss from disposal of $15.8 million (net of a $3.6 million tax benefit), as the adjusted carrying value of MWF exceeded the cash consideration, including amounts received at closing and expected to be received in the future. The third-quarter impairment charge and the fourth-quarter loss from disposal resulted in total sale-related charges of $276.3 million in 2004. Following settlement of the MWF cash balance in March 2005, CNF received cash of $29.4 million and recognized an additional first-quarter net loss from disposal of $9.8 million, primarily to recognize the difference between the actual cash received and CNF’s estimate of the cash position at December 31, 2004, and to accrue additional estimated transaction costs. In the remainder of 2005, CNF reported an $11.0 million net gain from additional adjustments in its estimated disposition loss, including a $9.0 million third-quarter net gain to recognize an increase in its estimate of deferred tax assets associated with employee benefit obligations retained by CNF, as more fully discussed below under “— Excluded Assets and Liabilities.”

 

CNF’s disposal of MWF generated a capital loss for tax purposes. Under current tax law, capital losses can only be used to offset capital gains. Since CNF did not forecast any significant taxable capital gains in the five-year tax carryforward period, the $40.8 million cumulative disposal-related tax benefit at December 31, 2004 was fully offset by a valuation allowance of an equal amount. In 2005, the cumulative disposal-related tax benefit and the associated valuation allowance declined to $30.0 million at December 31, 2005 due primarily to the third-quarter sale-related proceeds received from UPS and revisions to the tax effect of sale-related estimates, partially offset by the first-quarter disposal-related capital loss.

 

Excluded Assets and Liabilities

 

As described above, the stock purchase agreement excludes, and CNF has retained, the obligations related to MWF employees covered under certain CNF-sponsored employee benefit plans, including domestic pension, postretirement medical, and long-term disability plans that cover the noncontractual employees and former employees of both continuing operations as well as the discontinued Forwarding segment (collectively, the “CNF Benefit Plans”). Under the stock purchase agreement, UPS agreed to pay to CNF the estimated present value of CNF’s retained obligations related to MWF employees covered under CNF’s long-term disability and postretirement medical plans (the “Reimbursable Plans”). Accordingly, CNF in December 2004 recorded in Other Accounts Receivable a receivable for its estimate of the present value of the retained obligations of the Reimbursable Plans. Under an agreement reached in August 2005, UPS paid $79.0 million to CNF for the agreed-upon estimated present value of the retained obligations of the Reimbursable Plans. The carrying value of these obligations at December 31, 2005 was substantially equal to the cash reimbursement from UPS and the present value estimated by a third-party actuary as of CNF’s annual November 30 actuarial measurement date. Based on CNF’s intention to retain the obligation related to employees of MWF and EWA covered by the CNF Benefit Plans, the obligation is included in Employee Benefits of continuing operations in CNF’s Consolidated Balance Sheets at December 31, 2005 and 2004. The stock purchase agreement also excludes, and CNF has retained, the net prepaid benefit cost related to certain pension plans that cover only the former employees of the discontinued Forwarding segment (the “Forwarding Plans”). In CNF’s Consolidated Balance Sheets, the prepaid benefit cost related to the Forwarding Plans was reported in Assets of Discontinued Operations at December 31, 2004 and, based on CNF’s decision to retain these obligations and the completion of sale-related adjustments in 2005, was reclassified to Employee Benefits of continuing operations at December 31, 2005. Future changes in the carrying value of the retained obligations of the CNF Benefit Plans and the prepaid benefit cost of the Forwarding Plans will be recognized in future periods as income or loss of continuing operations.

EWA

 

The results of EWA relate to the cessation of its air-carrier operations in 2001 and to the termination of its Priority Mail contract with the USPS in 2000. In 2005, EWA recognized net losses of $9.0 million, due primarily to increases in the estimated exposure for litigation and restructuring-related obligations. EWA’s estimated loss reserves increased to $34.1 million at December 31, 2005 from $33.8 million at December 31, 2004 due primarily to the losses described above, partially offset by the cash settlement of restructuring-related obligations. EWA’s remaining loss reserves at December 31, 2005 were reported in Liabilities of Discontinued Operations and consisted mostly of CNF’s estimated exposure related to the labor matters described below, and other litigation-related losses, as more fully discussed in Note 11, “Commitments and Contingencies,” of Item 8, “Financial Statements and Supplementary Data.”

 

In connection with the cessation of its air-carrier operations in 2001, EWA terminated the employment of all of its pilots and crew members. Those pilots and crew members are represented by the Air Line Pilots Association (“ALPA”) union under a collective bargaining agreement. Subsequently, ALPA filed a grievance on behalf of the pilots and crew members protesting the cessation of EWA’s air-carrier operations and MWF’s use of other air carriers. The ALPA matters are the subject of litigation in U.S. District Court and, depending on the outcome of that litigation, may be subject to binding arbitration. Based on CNF’s current evaluation, management believes that it has provided for its estimated exposure related to the ALPA matters. However, there can be no assurance in this regard as CNF cannot predict with certainty the ultimate outcome of these matters.

 

Liquidity and Capital Resources

 

Cash and cash equivalents rose to $514.3 million at December 31, 2005 from $346.9 million at December 31, 2004, as $217.6 million of cash provided by operating activities and $179.3 million provided by investing activities exceeded $216.4 million used in financing activities. Cash provided by investing activities primarily reflects the net effect of a $284.0 million decrease in short-term marketable securities, $210.2 million of capital expenditures and $108.4 million in payments received from UPS in connection with the sale of MWF. The decline in short-term marketable securities brought the balance of those liquid investments to $202.4 million at December 31, 2005. Cash used in financing activities primarily reflects common stock repurchases of $149.1 million and debt repayment of $112.7 million.

CNF’s cash flows are summarized in the table below.

 

 

 

 

Continuing Operations

 

Operating Activities

 

Cash flow from operating activities in 2005 was $217.6 million, a $162.1 million decrease from 2004, as an increase in net income before non-cash items was more than offset by the net use of cash due to changes in assets and liabilities. Receivables in 2005 used $124.3 million on higher revenue and by an increase in the average collection period for Logistics’ receivables that was due in part to longer customer-negotiated payment terms and processing delays. The net use of cash from the decline in employee benefit liabilities for the years presented reflects the effect of defined benefit pension plan funding contributions of $126.5 million in 2005, $90.8 million in 2004 and $75.0 million in 2003, as described below under “ — Defined Benefit Pension Plans,” partially offset by expense accruals for CNF’s defined benefit plan obligations. Accrued incentive compensation decreased $20.1 million in 2005, while 2004 reflects a $29.4 million increase. In 2005 and 2004, expense accruals for incentive compensation were $68.6 million and $102.3 million, respectively, while incentive compensation payments in those years were $88.7 million and $72.9 million, respectively. Cash provided by changes in deferred charges and credits declined to $27.5 million in 2005 from $67.1 million provided in 2004 due primarily to $54.5 million of cash payments received in 2004 in connection with the liquidation of corporate-owned life insurance policies. In all years presented, cash provided by deferred charges and credits reflect variations in CNF’s affiliate payable to Vector, which is more fully discussed in Note 3, “Investment in Unconsolidated Joint Venture,” in Item 8, “Financial Statements and Supplementary Data.”

Operating cash flow in 2004 increased from 2003 by $153.4 million to $379.6 million. Higher operating cash flow in 2004 was due in part to an increase in net income before non-cash items, which in 2004 included a $276.3 million non-cash net loss from the disposal of MWF, and to asset and liability changes related to the liquidation of corporate-owned life insurance policies, accounts payable, and incentive compensation, partially offset by pension funding payments. Accrued incentive compensation increased in 2004 but declined in 2003 based on the timing of expense accruals and payments.

 

Investing Activities

 

Investing activities in 2005 provided $179.3 million compared to $224.3 million used in 2004. CNF received payments from UPS of $108.4 million in 2005 and $150.0 million in 2004, as more fully discussed below under “— Discontinued Operations.” In all periods presented, investing activities also reflect fluctuations in short-term marketable securities and capital expenditures. Investments in marketable securities decreased in 2005 by $284.0 million, primarily from the first-quarter conversion of auction-rate securities into cash and cash equivalents, while in 2004 and 2003, investments in marketable securities increased by $225.9 million and $169.4 million, respectively. Capital expenditures in 2005 increased $58.7 million from 2004 due substantially to expenditures at Con-Way, which increased to $197.6 million from $144.0 million in 2004 due largely to increased tractor and trailer acquisitions. Capital expenditures in 2004 increased $23.7 million from 2003, also due to increases at Con-Way.

 

Financing Activities

 

Financing activities used cash of $216.4 million in 2005 and provided cash of $175.5 million in 2004. In 2005, cash used in financing activities included $149.1 million used for the repurchase of common stock under CNF’s repurchase program described below. Financing activities in 2005 reflect the repayment at maturity on June 1 of the $100 million 7.35% Notes, while 2004 reflects the $292.6 million net issuance of 6.7% Senior Debentures and the $128.9 million redemption of 5% Convertible Debentures. Financing activities in all periods presented also reflect dividend payments and scheduled principal payments for the Thrift and Stock Plan notes guaranteed by CNF. Cash provided by the exercise of stock options increased to $76.1 million in 2005 from $56.1 million in 2004, and $6.4 million in 2003 due primarily to an increase in the market price for CNF’s common stock.

 

In January 2005, the Board of Directors authorized the repurchase of up to $300 million in CNF’s common stock from time to time during a two-year period in open-market purchases and privately negotiated transactions. In 2005, CNF used $149.1 million for the repurchase of common stock and currently estimates it will repurchase approximately $150 million of CNF’s common stock in 2006.

 

CNF has a $400 million revolving credit facility that matures on March 11, 2010. The $400 million revolving facility, which CNF entered into in March 2005, replaced a $385 million revolving credit facility. The revolving credit facility is available for cash borrowings and for the issuance of letters of credit up to $400 million. At December 31, 2005 and 2004, no borrowings were outstanding under CNF’s revolving credit facility and, at December 31, 2005, $215.1 million of letters of credit were outstanding, leaving $184.9 million of available capacity for additional letters of credit or cash borrowings, subject to compliance with financial covenants and other customary conditions to borrowing. The total letters of credit outstanding at December 31, 2005 provided collateral for CNF’s self-insurance programs. CNF had other uncommitted unsecured credit facilities totaling $35.0 million at December 31, 2005, which are available to support letters of credit, bank guarantees, and overdraft facilities; at that date, a total of $15.7 million of letters of credit was outstanding under these facilities. See “Other Matters — Forward-Looking Statements” below, and Note 5, “Debt and Other Financing Arrangements,” in Item 8, “Financial Statements and Supplementary Data,” for additional information concerning CNF’s $400 million credit facility and some of its other debt instruments.

 

Defined Benefit Pension Plans

 

As more fully discussed below under “Estimates and Critical Accounting Policies — Defined Benefit Pension Plans,” CNF periodically reviews the funded status of its defined benefit pension plans for non-contractual employees, and makes contributions from time to time as necessary to comply with the funding requirements of the Employee Retirement Income Security Act (“ERISA”). In determining the amount and timing of its pension

contributions, CNF considers both the ERISA- and GAAP-based measurements of funded status as well as the tax deductibility of contributions. CNF contributed $126.5 million to its defined benefit pension plans in 2005 and currently estimates it will contribute $75 million in 2006. CNF made defined benefit pension plan contributions of $90.8 million in 2004 and $75.0 million in 2003.

 

Contractual Cash Obligations

 

The table below summarizes contractual cash obligations for CNF as of December 31, 2005. Some of the amounts in the table are based on management’s estimates and assumptions about these obligations, including their duration, the possibility of renewal, and other factors. Because of these estimates and assumptions, the actual future payments may vary from those reflected in the table. These contractual cash obligations are reflected in the Consolidated Balance Sheets, except for operating leases, purchase obligations, and interest on long-term debt and guarantees, which are disclosed as future obligations under GAAP.

 

 

 

 

As presented above, contractual obligations on long-term debt and guarantees represent principal and interest payments while contractual obligations for operating leases represent the payments under the lease arrangements. The purchase obligations represent non-cancelable agreements to purchase equipment for Con-Way’s operations. Certain liabilities, including those related to pension and postretirement benefit plans and self-insurance accruals, are reported in CNF’s Consolidated Balance Sheets but not reflected in the table above due to the absence of stated maturities. As described above, CNF currently estimates that it will contribute $75 million to its defined benefit pension plan in 2006, which is subject to variation based on changes in interest rates and asset returns.

 

As described above under “— Continuing Operations,” letters of credit of $215.1 million were outstanding at December 31, 2005. These letters of credit are generally required under self-insurance programs and do not represent additional liabilities as the underlying self-insurance accruals are already reflected on CNF’s Consolidated Balance Sheets.

 

In accordance with GAAP, CNF’s operating leases are not included in CNF’s Consolidated Balance Sheets. CNF’s operating leases were determined to provide economic benefits preferable to ownership based primarily on after-tax cash flows, financial and operating flexibility, and the effect on CNF’s capitalization. Under certain operating leases, Con-Way guarantees the residual value of tractors and trailers at the end of the lease term. At December 31, 2005, the residual value guaranteed under these lease agreements was $4.1 million. CNF recognizes a liability for any shortfall between the residual value guarantee and the equipment’s estimated fair value, which fluctuates depending on market conditions.

 

In 2006, CNF anticipates capital expenditures of approximately $395 million (including software expenditures), an increase from $218.6 million in 2005. The increased level of capital expenditures consist primarily of $127 million related to land and buildings, including approximately $27 million for improvements, and $141 million for the acquisition of additional tractor and trailer equipment for Con-Way’s regional carriers. Con-Way’s truckload business expects to add $67 million of additional tractor and trailer equipment. Subsequent to December 31, 2005, Con-Way entered into additional agreements to acquire $91.8 million of revenue equipment for delivery in 2006.

For further discussion, see Note 5, “Debt and Other Financing Arrangements,” and Note 6, “Leases,” included in Item 8, “Financial Statements and Supplementary Data.”

 

Other

 

CNF’s ratio of total debt to capital decreased to 39.6% at December 31, 2005 from 47.9% at December 31, 2004, due primarily to the increase in retained earnings resulting from net income earned in 2005 and the repayment in June of the $100 million 7.35% notes.

 

On February 1, 2006, Standard & Poor’s raised its rating on CNF’s senior unsecured debt to “BBB” from “BBB-.” In addition, Fitch Ratings initiated coverage of CNF on January 25, 2006 with a rating of “BBB.” Both agencies reported the rating outlook for CNF as “stable.”

 

Discontinued Operations

 

On December 19, 2004, CNF completed the sale of MWF to UPS for $150 million in cash, subject to adjustment for cash held by MWF at closing and the net working capital of MWF as of closing. In March 2005, CNF received $29.4 million from UPS for the reimbursable cash held by MWF at closing, with no adjustment for net working capital. UPS agreed to pay to CNF an amount equal to CNF’s retained obligations related to MWF employees covered under CNF’s long-term disability and postretirement medical plans. Accordingly, CNF in December 2004 recorded in Other Accounts Receivable a receivable for its estimate of the present value of these employee benefit obligations. Under agreement reached in August 2005, UPS paid $79.0 million to CNF for the agreed-upon present value of the employee benefit obligations retained by CNF. The payments from UPS are more fully discussed above under “Results of Operations — Discontinued Operations,” and are reported as sale-related proceeds under investing activities in CNF’s Statements of Consolidated Cash Flows.

 

Estimates and Critical Accounting Policies

 

The preparation of financial statements in accordance with accounting principles generally accepted in the U.S. requires management to adopt accounting policies and make significant judgments and estimates. In many cases, there are alternative policies or estimation techniques that could be used. CNF maintains a process to evaluate the appropriateness of its accounting policies and estimation techniques, including discussion with and review by the Audit Committee of its Board of Directors and its independent auditors. Accounting policies and estimates may require adjustment based on changing facts and circumstances and actual results could differ from estimates. The policies and estimates discussed below include those that are most critical to the financial statements.

 

Self-Insurance Accruals

 

CNF uses a combination of insurance and self-insurance programs to provide for the costs of medical, casualty, liability, vehicular, cargo, and workers’ compensation claims. In the measurement of these costs, CNF considers historical claims experience, medical costs, demographic and severity factors, and other assumptions. Self-insurance accruals are developed based on the estimated, undiscounted cost of claims, including those claims incurred but not reported as of the balance sheet date. The long-term portion of self-insurance accruals relates primarily to workers’ compensation and vehicular claims that are payable over several years. The actual costs may vary from estimates.

 

Income Taxes

 

In establishing its deferred income tax assets and liabilities, CNF makes judgments and interpretations based on the enacted tax laws and published tax guidance that are applicable to its operations. CNF records deferred tax assets and liabilities and periodically evaluates the need for a valuation allowance to reduce deferred tax assets to realizable amounts. The likelihood of a material change in CNF’s expected realization of these assets is dependent on future taxable income, future capital gains, its ability to use foreign tax credit carryforwards and carrybacks, final U.S. and foreign tax settlements, and the effectiveness of its tax planning strategies in the various relevant jurisdictions. CNF is also subject to examination of its income tax returns for multiple years by the IRS and other tax

authorities. CNF periodically assesses the likelihood of adverse outcomes resulting from these examinations to determine the adequacy of its provision and related accruals for income taxes.

 

Disposition and Restructuring Estimates

 

As more fully discussed under “Results of Operations — Discontinued Operations,” CNF’s management made significant estimates and assumptions in connection with the disposition of MWF in 2004. Actual results could differ from estimates, which could affect related amounts reported in the financial statements.

 

Uncollectible Accounts Receivable

 

CNF and its subsidiaries report accounts receivable at net realizable value and provide an allowance for uncollectible accounts when collection is considered doubtful. Con-Way provides for uncollectible accounts based on various judgments and assumptions, including revenue levels, historical loss experience, and composition of outstanding accounts receivable. Logistics, based on the size and nature of its client base, performs a frequent and periodic evaluation of its customers’ creditworthiness and accounts receivable portfolio and recognizes expense from uncollectible accounts when losses are both probable and reasonably estimable.

 

Defined Benefit Pension Plans

 

CNF has defined benefit pension plans that cover employees and former non-contractual employees in the United States. The amount recognized as pension expense and the accrued pension liability depend upon a number of assumptions and factors, the most significant being the discount rate used to measure the present value of pension obligations and the expected rate of return on plan assets. CNF assesses its plan assumptions for the discount rate, expected rate of return on plan assets, and other significant assumptions on a continuous basis, but concludes on those assumptions at the actuarial plan measurement date in November of each year. CNF’s most significant assumptions used in determining pension expense for the periods presented and for 2006 are summarized below.

 

 

CNF adjusts its discount rate periodically by taking into account changes in high-quality corporate bond yields and the guidance of its outside actuaries. In determining the appropriate discount rate, CNF in 2004 began utilizing a bond model that incorporates expected cash flows of plan obligations. The bond model uses a selected portfolio of Moody’s Aa-or-better rated bonds with cash flows and maturities that match the projected benefit payments of CNF’s pension plans. CNF’s discount rate is equal to the yield on the portfolio of bonds, which will typically exceed the Moody’s Aa corporate bond index due to the long duration of expected benefit payments from CNF’s plan. If all other factors were held constant, a 0.25% decline in the discount rate would result in an estimated $7 million increase in 2006 annual pension expense.

 

CNF adjusts its expected rate of return on plan assets based on current market expectations and historical returns. The rate of return is based on an expected 20-year return on the current asset allocation and the effect of actively managing the plan, net of fees and expenses. Using year-end plan asset values, a 0.25% decline in the expected rate of return on plan assets would result in an estimated $2 million increase in 2006 annual pension expense.

 

Differences between the expected and actual rate of return on plan assets and/or changes in the discount rate may result in cumulative unrecognized actuarial losses. These unrecognized actuarial losses primarily reflect the declining discount rate and lower market returns in recent years. Although these amounts may be recovered in future periods through actuarial gains, any portion of the unrecognized actuarial loss outside of a corridor amount must be amortized and recognized as expense over the average service period for employees. Amortization of the unrecognized actuarial loss in 2005 declined $4 million from 2004, due primarily to a reduction in the difference between expected and actual returns on plan assets in 2004. In its determination of the plan obligation at

December 31, 2005 and of pension expense in 2006, CNF revised its mortality assumption for plan participants from one based on 1983 U.S. census data to one based on 2000 U.S. census data, which results in a longer-life assumption for plan participants.

 

CNF expects its defined benefit pension expense in 2006 will exceed expense in 2005 by approximately $6 million based on increases in service cost, interest cost, and amortization of the unrecognized actuarial loss, partially offset by a higher expected return on plan assets. The increase in service cost is due in part to the effect in 2006 of revised mortality assumptions while the increase in interest cost is due to the lower discount rate that increases the plan obligation. Despite unchanged expectations on the long-term rate of return on plan assets, CNF expects an increase in the return on plan assets in 2006 based on plan contributions that increase plan assets. Amortization of the unrecognized actuarial loss in 2006 will increase $4 million from 2005, based primarily on the higher unrecognized actuarial loss at December 31, 2005.

 

Under assumptions applied at the 2005 measurement date, the accumulated benefit obligation of certain CNF pension plans exceeded the fair value of plan assets. Accordingly, CNF recorded a minimum pension liability adjustment in Accumulated Other Comprehensive Loss of Shareholders’ Equity to recognize the shortfall between the fair value of the assets and the accumulated benefit obligation of these plans. At December 31, 2005, the cumulative additional minimum pension liability increased to $36.2 million (net of $23.1 million of tax benefits) from $14.7 million (net of $9.4 million of tax benefits) at December 31, 2004, due primarily to the remeasurement of the accumulated benefit obligation at a lower discount rate.

 

CNF periodically reviews the funded status of its defined benefit pension plans for non-contractual employees, and makes contributions from time to time as necessary to comply with the funding requirements of the Employee Retirement Income Security Act (“ERISA”). In determining the amount and timing of its pension contributions, CNF considers both the ERISA- and GAAP-based measurements of funded status as well as the tax deductibility of contributions. CNF contributed $126.5 million to its defined benefit pension plans in 2005 and currently estimates it will contribute $75 million in 2006, which is subject to variation based on changes in interest rates and asset returns. CNF made defined benefit pension plan contributions of $90.8 million in 2004 and $75.0 million in 2003.

 

Property, Plant and Equipment and Other Long-Lived Assets

 

In accounting for property, plant, and equipment, CNF makes estimates about the expected useful lives and the expected residual values of the assets, and the potential for impairment based on the fair values of the assets and the cash flows generated by these assets.

 

The depreciation of property, plant, and equipment over their estimated useful lives and the determination of any salvage value requires management to make judgments about future events. CNF periodically evaluates whether changes to estimated useful lives or salvage values are necessary to ensure these estimates accurately reflect the economic use of the assets. CNF’s periodic evaluation may result in changes in the estimated lives and/or salvage values used to depreciate its assets, which can affect the amount of periodic depreciation expense recognized and, ultimately, the gain or loss on the disposal of the asset.

 

CNF performs an impairment analysis of long-lived assets whenever circumstances indicate that the carrying amount may not be recoverable. For assets that are to be held and used, an impairment charge is recognized when the estimated undiscounted cash flows associated with the asset or group of assets is less than carrying value. If impairment exists, a charge is recognized for the difference between the carrying value and the fair value. Fair values are determined using quoted market values, discounted cash flows, or external appraisals, as applicable. Assets held for disposal are carried at the lower of carrying value or estimated net realizable value.

 

Other Matters

 

New Accounting Standards

 

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), a revision of SFAS 123 that supersedes APB 25 and its related implementation guidance. SFAS 123R eliminates the alternative to use APB 25’s intrinsic-value method of accounting that was provided in SFAS 123 as originally issued, and

requires companies to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards (with limited exceptions) over the period during which an employee is required to provide service in exchange for the award.

 

SFAS 123R also amends FASB Statement No. 95, “Statement of Cash Flows,” to require that the benefits associated with the tax deductions in excess of recognized compensation cost be reported as financing cash flows, rather than as a reduction of taxes paid. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after the effective date.

 

The effective date of SFAS 123R is as of the beginning of the first interim or annual reporting period of the first fiscal year beginning on or after June 15, 2005, which for CNF is the first quarter of 2006. In the adoption of SFAS 123R, CNF has concluded that it will continue its use of the Black-Scholes model for estimating the fair value of stock option grants and will apply the modified prospective transition method to all past share-based awards outstanding and unvested as of the effective adoption date of January 1, 2006. Under the modified prospective transition method, CNF will recognize the associated expense over the remaining vesting period based on the fair values previously determined and disclosed as part of the pro-forma disclosures presented in Note 1, “Principal Accounting Policies,” in Item 8, “Financial Statements and Supplementary Data.” The estimated annual compensation expense related to these unvested stock options in 2006 is approximately $0.07 per diluted common share. However, the calculation of total compensation expense for share-based awards after the effective date of SFAS 123R cannot be known at this time as it is affected by the number of future shares awarded, and it may be different from the calculation of pro-forma compensation expense under SFAS 123.

 

Forward-Looking Statements

 

Certain statements included herein constitute “forward-looking statements” within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and are subject to a number of risks and uncertainties, and should not be relied upon as predictions of future events. All statements other than statements of historical fact are forward-looking statements, including any projections of earnings, revenues, weight, yield, volumes, income or other financial or operating items, any statements of the plans, strategies, expectations or objectives of CNF or its management for future operations or other future items, any statements concerning proposed new products or services, any statements regarding CNF’s estimated future contributions to pension plans, any statements as to the adequacy of reserves, any statements regarding the outcome of any claims that may be brought against CNF by CFC’s multi-employer pension plans or any statements regarding future economic conditions or performance, any statements regarding the outcome of legal and other claims and proceedings against CNF; any statements of estimates or belief and any statements or assumptions underlying the foregoing.

 

Certain such forward-looking statements can be identified by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates” or “anticipates” or the negative of those terms or other variations of those terms or comparable terminology or by discussions of strategy, plans or intentions. Such forward-looking statements are necessarily dependent on assumptions, data and methods that may be incorrect or imprecise and there can be no assurance that they will be realized. In that regard, the following factors, among others and in addition to the matters discussed elsewhere in this document and other reports and documents filed by CNF with the Securities and Exchange Commission, could cause actual results and other matters to differ materially from those discussed in such forward-looking statements:

 

 

 

As a result of the foregoing, no assurance can be given as to future financial condition, results of operations, or cash flows. See Note 11, “Commitments and Contingencies” in Item 8, “Financial Statements and Supplementary Data.”

 

CNF is exposed to a variety of market risks, including the effects of interest rates, fuel prices, and foreign currency exchange rates. CNF enters 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 interest rate, commodity, 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.

 

Interest Rates

 

CNF is subject to the effect of interest rate fluctuations on the fair value of its long-term debt. Based on the fixed interest rates and maturities of its long-term debt, fluctuations in market interest rates would not significantly affect operating results or cash flows, but may have a material effect on the fair value of long-term debt. The table below summarizes the carrying value of CNF’s fixed-rate long-term debt, the estimated fair value, and the effect of a 10% hypothetical change in interest rates on the estimated fair value. The estimated fair value is calculated as the net present value of principal and interest payments discounted at interest rates offered for debt with similar terms and maturities.

 

 

As more fully discussed in Note 5, “Debt and Other Financing Arrangements,” in Item 8, “Financial Statements and Supplementary Data,” CNF in December 2002 terminated four interest rate swap derivatives designated as fair value hedges of fixed-rate long-term debt. Except for the effect of these terminated interest rate swaps, derivative financial instruments did not have a material effect on CNF’s financial condition, results of operations, or cash flows.

Fuel

 

CNF is exposed to the effects of changes in the availability and price of diesel fuel. Generally, fuel can be obtained from various sources and in the desired quantities. However, an inability to obtain fuel due to fuel shortages or any other reason could have a material adverse effect on CNF. CNF and its subsidiaries (primarily Con-Way) are subject to the risk of price fluctuations. Like other LTL carriers, Con-Way assesses many of its customers with a fuel surcharge. The fuel surcharge is a part of Con-Way’s overall rate structure for customers and is intended to compensate Con-Way for the adverse effects of higher fuel costs. As fuel prices have risen, the fuel surcharge has increased Con-Way’s yields and revenue, and Con-Way has more than recovered higher fuel costs and fuel-related increases in purchased transportation. At times, in the interest of its customers, Con-Way has temporarily capped the fuel surcharge at a fixed percentage. Following a sharp increase in fuel costs in the aftermath of hurricanes in the U.S., Con-Way imposed a temporary cap on its fuel surcharge in 2005 that was in effect from August 29 through October 24. CNF cannot predict the future movement of fuel prices, Con-Way’s ability to recover higher fuel costs through fuel surcharges, or the effect that changes in fuel surcharges may have on Con-Way’s overall rate structure. Con-Way’s operating income would likely be adversely affected by a rapid and significant decline in fuel prices as lower fuel surcharges would reduce Con-Way’s yield and revenue. Whether fuel prices increase, decrease, or remain constant, Con-Way’s operating income may be adversely affected if competitive pressures limited Con-Way’s ability to assess its fuel surcharges.

 

Foreign Currency

 

The assets and liabilities of CNF’s foreign subsidiaries are denominated in foreign currencies, which create exposure to changes in foreign currency exchange rates. However, the market risk related to foreign currency exchange rates is not material to CNF’s financial condition, results of operations, or cash flows.

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Shareholders CNF Inc.:

 

We have audited the accompanying consolidated balance sheets of CNF Inc. and subsidiaries as of December 31, 2005 and 2004, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the years in the three-year period ended December 31, 2005. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of CNF Inc. and subsidiaries as of December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2005, in conformity with U.S. generally accepted accounting principles.

 

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of CNF Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in “Internal Control — Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2006, expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.

 

KPMG LLP

 

Portland, Oregon
March 13, 2006

 

CNF Inc.
Consolidated Balance Sheets

 

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

CNF Inc.
Consolidated Balance Sheets

 

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

CNF Inc.

 

Statements of Consolidated Operations

 

 

The accompanying Notes to Consolidated Financial Statements are an integral part of these statements.

CNF Inc.

 

Statements of Consolidated Cash Flows